Which Funding Option is Right for You? What Every Founder Should Know about SAFEs, Convertible Notes, and Priced Rounds
By: Suhani Pandya, Venture Analyst at 1435 Capital Management
You and your co-founder have just decided to raise your first round of outside capital. Where should you start? From SAFEs to convertible notes to priced rounds, a range of funding options are available to you.
For first-time founders navigating the complex world of startup financing, understanding the difference between funding options is essential. Each constitutes a different approach to raising capital and poses unique implications in terms of valuation, dilution, risk, and control.
Priced rounds, which can generate buzz around a startup, are associated with heavy legal costs and result in immediate dilution. Convertible notes and SAFEs, which provide founders with more freedom and can be carried out in a short period of time, both come with risks: convertible notes add debt and interest expenses to a startup’s balance sheet, while SAFEs can create surprise dilution.
Priced Round (Equity Round):
A priced round, in which founders sell preferred shares of their company to investors at a negotiated valuation, is the most common way to fundraise. Priced rounds usually involve participation from a group of venture capital firms, but one investor leads the round by contributing the largest portion of the total amount.
Because the valuation has been decided in priced rounds, investors receive stock immediately, providing founders with certainty as to how much they’ll be diluted. Priced rounds are also beneficial in that they provide startups with credibility in the investor community.
Simultaneously, priced rounds come with their share of drawbacks. To close an investment, a venture capital firm and a startup must engage in discussions to agree on the firm’s control rights and liquidation preference, among other factors. Therefore, priced rounds can rack up legal fees for startups who must negotiate term sheets and go through the investor diligence process. According to Carta, raising through a priced round can lead to roughly $40-120K in costs for a startup.
Priced rounds can significantly impact a company’s 409A fair market valuation (FMV). Since the strike price of options given to employees must be set at or above the 409A FMV, options granted after the round will have a higher strike price, making it more expensive for future employees to purchase shares.
Convertible Notes
A convertible note is a short-term debt instrument that turns into equity once an exit event or subsequent priced round occurs.
When a startup raises a convertible note, a venture capital firm invests a principal amount of capital into it. Startups pay interest on the principal amount until a conversion event occurs or until the note nears its maturity date, at which point the startup can either engage in negotiations to extend the term or pay back the principal amount with accrued interest.
To offer a degree of protection to investors, the terms of convertible notes often include a valuation cap and/or a discount rate. The valuation cap is the maximum valuation at which an investor’s shares can be converted into equity, while the discount rate is a percentage that indicates the price reduction an investor will receive on the shares they ultimately get. For example, if the discount rate is 15%, the principal amount will be converted into shares priced at 85% of their true valuation.
Convertible notes provide more flexibility and are faster to execute than equity rounds, making them ideal for early-stage or bridge rounds. However, they add debt to a startup’s obligations and require that startups make interest payments, which can pile up to a significant expense.
Simple Agreements For Future Equity (SAFE Notes):
The startup accelerator Y Combinator created the concept of the SAFE (Simple Agreement for Future Equity) in 2013 to simplify early stage funding for startups. Like convertible notes, SAFEs enable investors to make a cash investment in the present in exchange for equity at a later date. However, SAFEs do not involve a debt element: startups do not pay interest and are not obligated to repay the cash investment.
Still, SAFEs do provide some incentives for investors: a valuation cap, a discount rate, and/or a most favored nation clause, which allows investors to convert their investment to shares at the best terms the startup has offered to other investor parties.
Like convertible notes, SAFEs are much faster to execute than priced rounds and require fewer legal fees. SAFEs also involve more uncertainty for investors because they rely on the fact that the startup will raise a future priced round at a significantly higher valuation. Some firms may be hesitant or decline to invest in SAFEs.
Conclusion
So what’s the right choice for you – priced rounds, convertible notes, or SAFEs? It depends where your startup is right now and what you value most: fast access to funds, publicity in the investor community, cap table and ownership clarity, a debt-free balance sheet, or another factor.
That said, founders at the seed or pre-seed stage most often raise unpriced rounds, amassing capital through convertible notes and SAFEs. Unpriced rounds are more suited to such founders, whose companies don’t have set valuations, run on a tighter budget, and tend to face more unpredictability.
Choosing which funding vehicle is right for you is a matter of balancing your timeline and immediate capital needs with long-term financial and strategic considerations.
Sources
https://www.capboard.io/en/captable/convertible-notes
https://corporatefinanceinstitute.com/resources/fixed-income/convertible-note/
https://www.archangel.vc/post/founders-dilemma-priced-equity-rounds-vs-safes
https://foundersnetwork.com/convertible-note-vs-equity/
https://www.startuppercolator.com/a-crash-course-on-safes/
https://carta.com/learn/startups/fundraising/priced-rounds/
https://www.ycombinator.com/documents
https://www.amplifypartners.com/blog-posts/safes-vs-priced-equity-rounds