There are multiple options available to entrepreneurs when they want to raise capital. They can pursue grants (free money), take on debt (borrow money) or split the piece of the ownership pie by taking on additional partners through equity investment.
In between equity and debt is a category that’s called “convertible security.” This type of security is a hybrid between debt and equity. There are a variety of these options.
Unfortunately, these securities can get rapidly confusing for founders. Moreover, some are more far appropriate at different stages than overs. You want to be careful not to take on securities now that could jeopardize your ability to raise capital in future rounds.
To help, here is a simplified run down of these securities and your options for using them in your startup:
Common stock and preferred equity
Before we jump into the wild world of convertible securities, let’s first refresh ourselves on corporate structure. The foundation of any corporation is common stock. Common stock represents ownership in a company and almost always comes with voting rights at shareholder meetings.
In addition to common stock is preferred equity. Unlike common stock holders, preferred equity usually does not have voting rights. What they get instead is priority treatment in case the company goes bankrupt and there are liquidation procedures. They also typically enjoy either priority in receiving dividends or fixed dividends.
Convertible Equity: equity that converts into more equity
Now, some securities, called convertible equity, start off as equity but can be converted into different equity under trigger events. The best example of this would be preferred equity that also happens to be structured to be convertible. Sometimes, preferred equity has a clause that it can convert into a common share if a certain event – say, a funding round – is triggered.
SAFE Notes: also converts into equity
A Simple Agreement for Future Equity (SAFE) is a financial instrument commonly used in early-stage startup financing. It straddles a strange milieu between equity and debt.
SAFE notes represent the right to obtain equity in a future financing round, with the conversion terms triggered by specific events. Unlike traditional convertible debt, SAFEs do not carry an interest rate or a maturity date. But they are also not equity.
One crucial element of a SAFE is the valuation cap, which sets the maximum valuation at which the investment will convert into equity. For example, if an investor participates in a SAFE with a $5 million valuation cap and the startup undergoes a subsequent funding round at a $10 million valuation, the investor’s SAFE converts as if the valuation were capped at $5 million. Therefore, the investor effectively gains equity at a lower valuation, reflecting the early support provided.
SAFE notes are often good options for early-stage financing, since the cost to complete them is lower, and they incentivize investors who are willing to come onboard early.
Convertible debt: debt that becomes equity
Then there is convertible debt, which is a debt that becomes equity.
There are many kinds of convertible securities: promissory notes, loan agreements, debentures, and bonds. However, while the structural details of these securities range, the main format remains the same – (1) like normal debt, they typically all set an interest rate on the principal. (2) Unlike normal debt, there is some predetermined event that will trigger a conversion into equity.
A comparison of equity, SAFEs and convertibles
So, what’s best for you and your company? It really depends on what your goals are.
Let’s start with the easy stuff. SAFE Notes cost the least to create, have the shortest agreements, and are generally very flexible to use if you want to raise from investors continuously and quickly.
Equity is the next cheapest option to complete, with subscription agreements that are longer than SAFEs but much shorter than debt agreements. Of course, with common equity, you are giving away voting rights and a percentage of the upside. Founders need to be thoughtful about how much of their earning and decision-making power they give away. The flip side is that equity can create a high degree of alignment for your path forward.
Meanwhile, agreements for convertible debt are lengthy and can take significant time and cost to complete.
So, when does it make sense to issue a convertible note?
Economically, any convertible investment in an early-stage company has a similar potential payout to a straight equity investment, notwithstanding the protection for the conversion price. And, while one of the primary benefits of a convertible security “should theoretically be” seniority of principal in the case of bankruptcy, in practice, when startups go bankrupt, there is often minimal value to be salvaged.
In other words, convertible debt can be really expensive to issue and not that protective to investors in the case of worst-case scenarios, anyway. The best time to issue them is you usually when you have no other options and the amount of money you can raise is substantial enough to cover the associated legal fees.
| Item | SAFE | Equity | Convertible Debt |
| Cost | Low cost | Higher than SAFE but lower than debt | Highest cost to complete The total costs depend on the exact terms, but loan and security documents make this the highest cost to issue. The costs may be prohibitive relative to the size of the raise. |
| True claim on company | Ranks ahead of equity in liquidation. The principal amount must be repaid prior to any amount to shareholders. | Residual (last) claim, but the highest potential return. | Ranks ahead of equity in liquidation. The principal amount must be repaid prior to any amount to shareholders. |
| Size of agreements | Short SAFE agreement | Subscription agreement longer than SAFE but much shorter than debt agreements | Lengthy loan and security documents |
| Valuation | Lower of discount to the price of the next equity issue or a valuation cap | Locks-in post-money valuation at time of investment | Lower of discount to the price of the next equity issue or a valuation cap |
| Flexibility | Can raise from multiple investors quickly and continually | Group investors into clear rounds | Group investors into clear rounds |
| Time to completion | Fast | Slower than SAFE but faster than debt | Long time period to complete required for negotiations and revisions of documents |
| Interest | None | Not applicable | Yes |
