Do investors prefer SAFE or convertible note?
Investor preference:
In general, SAFE agreements are considered more founder-friendly because they provide more flexibility and don't carry interest. Convertible notes tend to be more investor-friendly because the maturity date imposes more restrictions on founders.
Convertible securities have a key advantage: They allow founders to raise capital without a set valuation. This matters because very early stage startups typically have not yet raised a “priced round” from investors, and the market has not yet set a value on how much their company is worth.
Meanwhile, venture investors use convertible notes for their own reasons: Negotiating favorable conversion terms. Since they're coming in at an earlier stage, investors can often negotiate for favorable conversion terms, such as a lower valuation cap or higher discount.
Convertible note financings are simpler to document from a legal perspective. This means that they are generally less expensive from a legal perspective and that the rounds can be closed more quickly.
The idea behind SAFEs is that, because they are simple and standardized, investors and startup companies save both time and money to focus on growing the business; less time is spent negotiating terms of the investment, and less money is spent in legal fees to address the details of that investment.
They are considered more founder-friendly than convertible notes as they do not have to be repaid if the venture is unsuccessful. SAFE notes were created in 2013 by an organisation in the US called Y Combinator, which provides seed funding, mentorship, and resources to start-up companies.
In summary, convertible notes provide interest deductions for startups but reduce available cash, while interest payments to investors are taxed as income. SAFE notes don't impact a startup's cash flow but investors may benefit from lower capital gains taxes down the road.
Lack Of Interest Payments: Unlike debt instruments, SAFE notes don't typically offer interest payments, which could be a disadvantage for investors seeking immediate returns. Investor Risk: In the case of a successful startup, investors might end up with a smaller equity stake compared to a fixed valuation.
Low-Risk Investment
There is also less to gain—either in terms of the potential return or the potential benefit bigger term. Low-risk investing not only means protecting against the chance of any loss, but it also means making sure that none of the potential losses will be devastating.
Do convertible notes dilute new investors?
The convertible note investor will be paying half-price for shares relative to the new investors. The cap is usually the most significant point of negotiation. If it's set too low, the founder's stake gets heavily diluted. If it's too high, the investor loses out.
However, convertible notes also have some drawbacks: they create debt obligations for the startup, dilute the founder's ownership and control, create misalignment between investor and startup incentives, and complicate the cap table and funding rounds by introducing multiple classes of shareholders with different ...
The main disadvantages of convertible note offerings are equity dilution and near‐term stock price impact and, if the stock price fails to appreciate above the conversion price, potential refinancing risk.
If the company fails, the investors who provided funding through the SAFE will typically have to write off their investment as a loss. This means that they will not be able to recoup the money they invested, and will need to consider the investment as a loss for tax purposes.
SAFE notes are a very attractive alternative for early-stage startups to raise funding. SAFE (simple agreement for future equity) gives investors the right to buy equity in a startup at a future date when the startup has another round of fundraising.
They may be more attractive to investors since convertible bonds provide growth potential through future capital appreciation of the stock price.
Legal fees can be modest, but so are the protections. Like all early-stage investments, SAFEs can be especially risky because when you provide the funding, you don't end up owning anything. In the event of a liquidation or wind-down, you may get nothing if the SAFE hasn't already converted.
SAFE notes seem like good deals to startups and investors because they aren't recorded as debt, they save time and money with regards to negotiation, and they still include valuation caps and discounts. However, they don't carry interest, do change to stocks at a specific time, and can't be declared when in default.
If you invest in a SAFE that only has a valuation cap and no discount rate, it's possible that upon conversion you'll get no better terms than later investors. You won't earn interest. Over the short term, this may not matter much.
Convertible shares can be a good choice for an investor who wants the safety of a guaranteed return plus the potential for a greater return down the road. They can be a good way to invest some money in the stock market while keeping your overall risk low.
Why do angel investors prefer convertible debt?
Here's why: the main things convertible notes have going for them are: (i) they are cheaper to put together because there are fewer legal documents and they are simpler (ii) they are less complex and have fewer variables to negotiate, particularly deal price which is a perennially thorny topic that entrepreneurs like ...
Preferred shares, as we saw, offer several advantages to VCs; for example, they can help them mitigate risk. Typically, preferred stockholders will get higher liquidation preferences, anti-dillution protections, and protective provisions that allow them to limit decisions that can impact their investment.
There are some disadvantages to convertible bond issuers, too. One is that financing with convertible securities runs the risk of diluting not only the EPS of the company's common stock but also the control of the company.
Dilution and Overcrowding
One of the most painful consequences of misusing or overusing SAFE notes is equity dilution. The more shares early investors agree to purchase, the less of your company you eventually own when the notes convert. That means less control over your organization's future.
The discount in a SAFE is used as a mechanism to address the higher risk of investment that SAFE investors take when investing in an early-stage startup. It is a discount off the price per share paid by new investors in the equity financing. The discount may range anywhere between 5% to 30%, with 20% being the norm.
