SAFE Agreement vs Convertible Note
Startups are becoming more widespread with technology making it increasingly easy to enter new markets and gain a consumer base. This is why it comes as no surprise that investors poured $329.5 billion into startup investments in 2021, resulting in a 92% increase from 2020.
Investors are ready and willing to jump into a business with an innovative idea or plans for a steady return on investment, making it vital to consider the different funding methods you might use. SAFE agreements and convertible notes are two popular seed funding options, resulting in the need to understand the basics of each and how to choose the right one for your startup.
What is a SAFE Agreement?
Simple agreements for future equity, often referred to as SAFE, are legal contracts that startups utilize to raise seed financing. These agreements are simple to create and have straightforward language and standard provisions. Due to the simplicity, the turnaround time to receive funds is often very shortly after the agreement is signed.
SAFE agreements outline a specific conversion method and convert when the next round of preferred stock is issued. Since startup companies are difficult to properly value, SAFE agreements delay the valuation until a future date, giving the company the ability to raise additional funds and increase the valuation amount.
What is a Convertible Note?
The alternative to a SAFE agreement is a convertible note. This seed investment type creates a short-term debt note that converts into equity on the maturity date. Instead of receiving interest and principal payments like a traditional loan, investors will be granted a share of equity in the company.
Many entrepreneurs use convertible notes as a way to invest in their own companies without looking suspicious. Founders are generally granted a discounted purchase price of the company’s shares, which they turn around and sell at a higher price. By using a convertible note, there is less suspicion by the IRS surrounding the sale.
Choosing Between the Two
Both of these seed financing options carry different advantages and disadvantages. SAFE agreements are best if you are looking for a quick infusion of cash without reporting a debt obligation on your financial statements. However, investors are more familiar with convertible notes and may prefer that financing method.
On the other hand, convertible notes are great for tech-intensive companies that need a longer period to develop their product without jumping through hoops to issue equity right away. Additionally, convertible notes are seen as a solid investment for many seed investors because of the potential for a high return. However, convertible notes may come with the inability to raise future capital because of the debt agreement and the process can become complicated and time-consuming.
IN SUMMARY:
Which seed funding method looks more appealing for your business? This can be a tricky decision to make as both options come with pros and cons that need to be considered. One way to ensure you are making the right choice for your business is to consult with an expert. Divocate Consulting has years of experience walking clients through the specifications that equity financing will have on their business. Reach out today to set up a consultation.
