- within Finance and Banking topic(s)
- with readers working within the Retail & Leisure industries
- within Finance and Banking, Consumer Protection and Environment topic(s)
Introduction
Financing is an important component of every company's formation and growth. For early-stage companies, founders often face the important decision of selecting the investment model that best supports the company's development. While there are several financing options available such as direct equity investments and debt financing, this newsletter focuses on Simple Agreements for Future Equity (SAFEs) and Convertible Notes.
Understanding the differences between SAFEs and Convertible Notes is essential for investors and founders seeking to balance risk and growth opportunities in early-stage financing.
Understanding a SAFE
Introduced by Y Combinator in 2013, a SAFE is a contractual instrument through which an investor provides funding in exchange for the right to receive equity at a later date and upon the occurrence of a specified triggering event. Under a SAFE, the investor's return is realized when the company undergoes a liquidity-triggering event. These triggering events are usually defined in the agreement and may include events such as a merger, acquisition, an initial public offering (IPO), a change of control, etc.
SAFEs can be structured in several ways depending on the terms negotiated. The common structures include: (i) a discount, no valuation SAFE, where the investor converts their investment into equity at a discounted price compared to new investors in a future financing round; (ii) a valuation cap, no discount SAFE, which sets a maximum company valuation at which the investment will convert into equity; (iii) a valuation cap and discount SAFE, combining both protections for the investor; and (iv) a Most Favoured Nation (MFN) SAFE, which contains neither a discount nor a valuation cap but allows the investor to adopt more favourable terms offered to future SAFE investors. For more details, please read our newsletter here.
Understanding Convertible Notes
Convertible Notes represent a more traditional approach to early-stage financing. Structurally, they are debt instruments that convert into equity or repayment. When an investor provides funds through a Convertible Note, the company is technically borrowing money. The note includes a principal amount, an interest rate, and a maturity date. It is designed to convert into equity or repayment upon maturity.
This structure means that Convertible Notes begin as debt obligations but transform into ownership stakes when a qualifying financing event occurs. Interest accrued over time is usually added to the principal amount before conversion. The maturity date also introduces an additional layer of protection for investors to recoup their investments.
Distinction Between SAFEs and Convertible Notes
The most fundamental distinction between SAFEs and Convertible Notes lies in their classification. A SAFE is not a debt instrument, rather, it represents a contractual right for an investor to receive equity in the company in the future upon the occurrence of specified triggering events. As a result, a SAFE does not create an obligation for the company to repay the invested funds and does not accrue interest over time.
Convertible Notes, by contrast, are debt instruments that are designed to convert into equity at a later stage. When funds are provided through a Convertible Note, the company owes the investor the capital sum until the note converts or is repaid. Prior to conversion, the investment typically accrues interest and is subject to a fixed maturity date. At maturity, the principal and any accrued interest may convert into equity depending on the terms of the agreement. These features generally provide investors with additional protection and leverage, while SAFEs tend to offer companies flexibility and no immediate financial obligations.
Conclusion
As Nigeria's startup ecosystem continues to expand, founders and investors will increasingly encounter alternative financing instruments when raising capital. SAFEs and Convertible Notes both serve this purpose, providing an avenue through which companies can secure funding at the early stages of growth.
Choosing between the two often depends on the growth objectives of the company and the level of protection investors seek. Regardless of the structure adopted, obtaining professional legal advice and maintaining a clear understanding of the conversion mechanics are essential to ensuring that both founders and investors are adequately protected.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
