SAFE and convertible notes offer great opportunities for new companies to raise capital through investors. While not as common-place in Australia as they are in the US, recently there is a growing interest amongst companies over their use. The notes are agreements between investors and a company that in return for an initial investment, they will receive equity in the company. Both perform similar functions, though SAFE notes are a relatively new way of performing these. Here’s our breakdown of these two notes, and how they compare.
A convertible note is an agreement whereby an investor provides funding to a new company in return for future equity. As the name suggests, the note means that at some predetermined maturity date, usually after the initial funding round, the value put forward by the investor will be converted and returned as shares.
This is particularly good for investing in companies without value. As the share prices rise, so does the amount the investor gains. However, as it is a new company there is a significant amount of risk born by the investor. Hence, the features of the note look to compensate for that risk. These features are:
When the investment (sometimes referred to as a loan) converts, it converts at a price per share. The discount rate is a promise that when this conversion occurs, the investor will receive their shares at a lower price. For example, an investor takes a convertible note for $10,000 with a promised discount rate of 35%. If at the time of conversion, the company’s shares were trading at $10, these would then be discounted to $6.50. Hence, that $10,000 would mean they gain 1,538.5 shares (10,000/6.5 = 1,538.5) rather than the 1000 shares a regular investor would be able to afford with that same money (10,000/10 = 1000).
Either as an alternative to or in addition to a discount rate, a valuation cap restricts the price the investor will pay per share. For example, a cap at $6 per share means that if the share price payable for the investor is beyond $6 at the time of conversion, no matter what the investor will receive shares at a rate of $6 a share.
Most convertible notes will actually accrue interest until conversion. Unlike most loans, however, this interest then also becomes equity at conversion. Returning to our previous example, if the note was to gain interest at a rate that left its value at $11,000 at the point of conversion, then the investor would gain 1,692 shares (11,000/6.5 = 1,692) instead of 1,538.5!
A simple agreement for future equity (SAFE) is a simpler form of a convertible note. Unlike a convertible note, the SAFE does not accrue interest or have a maturity date. Instead, it simply provides a cap value for the investor to then receive stock at a future equity round.
So, for example, a SAFE that sets out a loan of $10,000 with a market cap of $3 during the companies first equity round, will convert automatically. Regardless of whether the companies shares are trading at $3.50 or even $100, you will receive them at $3.
However, as they don’t have a maturity date, without an equity round they do have the potential to leave the investor in limbo. Further, as with any company, the longer a company sits without an equity round, the more they run the risk of running out of funds and entering liquidation. Yet, holders of SAFE notes do rank highest in the event of liquidation, ahead of actual shareholders.
Of note, however, a SAFE note is not actually recognised by name in Australian Law. If you wish to form one, the instrument (agreement) will need to outline the functions of the agreement. You cannot simply say that it is a SAFE agreement.
Ultimately, both notes offer great ways for new companies to raise capital from investors. They also offer investors potentially great gains when the company they invest in takes off. Of note, in Australia, if you do hold these notes, you will be required to pay Capital Gains Tax (CGT) on them once they have been converted. However, you won’t need to pay CGT if you sell the note prior to conversion. Any proceeds or losses from the sale will fall within your personal income come tax time.
If you wish to form notes like these, its best to first seek the advice of a lawyer to review the agreement. Also, be aware of the potential for share dilution. Just because the agreement allows you to purchase the shares at a discounted rate, doesn’t mean that by that time each share will have the same weight as what you thought. If you’re looking for control in a company, you may have less than you thought by the time your note converts.