How Convertible Notes and SAFE Notes Affect Your Equity Ownership?

First things first ...

What is a Convertible Note?

A convertible note refers to a short-term debt instrument (security) that can be converted into equity (ownership portion in a company). Convertible notes are often used by seed investors who invest in startups. They are structured as loans to convert them to an equity stake in the company in the future.

What is a SAFE note?

SAFE (Simple Agreement for Future Equity) - simple legal agreements - introduced by Y Combinator in 2013, is a type of investment commonly used by startups to raise capital from early-stage investors, allowing them to postpone assigning a valuation to their company.

Download the SAFE agreement on the YC website, and mutually sign with your investors. The new version (Sept-2018) incorporates certain changes, which are here.

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Why Early Investors often use convertible notes or SAFEs?

Early Investors (notably Angel Investors / Syndicate) often use convertible notes or SAFEs as it allow them to invest relatively small amounts of funding at an early stage of a startup, when it has little or no revenue, thereby giving them more time to evaluate if to invest substantial amount later on. Instead of focusing on valuation during early stages, you agree on a valuation cap or discount rate with the investor.

Understanding the "Discount Rate" and "Cap"

The discount rate is the discount percentage that a note or SAFE holders investor receives on the price of shares in the next equity financing round. If a startup offers a 20% discount and the share price is $10, then investors can buy shares at $8 (at 20% discount).

A cap is a way for note or SAFE holders to protect themselves against the dilution that would come from a startup raising a priced round at a high valuation, basically locking in a minimum future equity stake.

Here's, how the CAP works:

A $5 million cap would mean that a SAFE or note holder would own the same equity ownership of the startup for any amount raised at ($5 Mn) or above the cap (e.g., $8 Mn).

But, here's the catch: If you raise money below the cap, you might end up giving away more of your startup than you expected. Check out below calculation.

At a pre-seed round, you're in the weakest negotiation position (with investors) than you'll ever be. Bootstrap, until you've the leverage to negotiate fairer terms - Steve Jennis.

How Convertible Notes and SAFEs Impact Equity in the Long Run?

Let's explore how convertible notes and Simple Agreements for Future Equity (SAFEs) can impact how much of your startup you own in the long run. We'll look at 4 different scenarios, and for each scenario, you offer a 20% discount and set a cap of $8 million. And, we'll assume that everything after the seed round (Series A & beyond) stays the same:

1. 250K Notes at $10 Mn valuation

2. 750K Notes at $10 Mn valuation

3. 250K Notes at $5 Mn valuation

4. 750K Notes at $5 Mn valuation

Let's look at 2 examples:

Scenario 1: Your startup raises $2.5 Mn in Seed (priced) round at a $10 Mn valuation.

Scenario 2: Your startup raises $1.5 Mn in Seed (priced) round at a $5 Mn valuation.

Scenario Source: SVB

By comparing these scenarios, one can see (and judge) how the cap and the valuation of your seed round can affect your ownership stake in the long term.

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Summary

Convertible notes and SAFEs are valuable tools for early-stage fundraising (Pre-seed and Seed), offering flexibility for both startups and investors. However, understanding the implications of discount rates and caps is crucial. Raising money at a lower valuation than the cap (aka down round) can lead to greater dilution of your ownership.

Carefully consider these factors before finalizing any agreements. By understanding their impact, you can make informed decisions to protect your long-term equity ownership.

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Related article: How to Raise Pre-seed or Seed Funding in Tranches?

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