The selection between SAFE, Convertible Notice & Fairness is as vital because the phrases
As an early-stage angel investor, I see dozens of pitches every month. The offers are cut up roughly equally between SAFEs, convertible notes, and fairness.
After I ask founders why they picked one over the opposite, the standard reply is “It was best” or “It’s what our lawyer advised us to do.”
What is usually missed is that the monetary instrument is as vital to buyers because the deal phrases and might have a big impact on the corporate’s success. The three totally different monetary devices utilized in enterprise investing supply trade-offs in simplicity, taxation, and management.
It’s vital to know the devices and select one of the best one in every funding spherical.
What’s Widespread Fairness?
As a founder, you maintain frequent fairness. Your staff, executives, and advisors get frequent fairness (or choices to buy frequent fairness). That is the fundamental type of inventory in an organization. While you purchase inventory in Netflix or Tesla on the inventory trade, you’re shopping for frequent fairness.
However buyers don’t need frequent fairness. We would like Most popular Shares which give us rights and protections not included in frequent fairness.
What’s Most popular Fairness?
As exterior buyers, we sometimes request/demand circumstances akin to:
- Liquidity choice: in an exit, we receives a commission again our funding (or some a number of of it) earlier than frequent shareholders get any payout
- Board seat or observer rights: we get a consultant on the board of administrators, or at the very least the suitable to attend all board conferences
- Data rights: we get common monetary updates
- Participation rights: we get the suitable to purchase shares in future rounds
Since decision-making is by a majority vote of the shareholders and the founders personal a majority of the shares, the one technique to assure these rights is to have a separate class of shares.
Most popular Shares Class A (Collection A) is the primary spherical of most well-liked shares. Most popular Shares Class B is the second. Since totally different rounds of buyers will be in battle with one another, every spherical of funding will get its personal separate share class with a special value and totally different rights, and separate voting.
Whereas there are good templates akin to Collection Seed that may make it simple to supply most well-liked shares, it’s normally a protracted course of involving costly attorneys on either side.
The inventory buy settlement itself runs about 25 pages. It needs to be accompanied by an amended certificates of incorporation and voting settlement, an investor rights settlement, a proper of first refusal settlement, and an inventory of disclosures. In complete, there are round 100 pages of authorized crap that must be agreed upon. Most of it’s boilerplate, however as a rule consists of severe errors that must be discovered and corrected.
Along with your personal authorized charges of about $10K, the startup could also be required to pay the authorized charges of the lead investor, too. It might take a month of backwards and forwards between attorneys and buyers earlier than everyone seems to be glad.
If it is a large spherical with a giant investor, most well-liked shares would be the solely alternative. But when I need to write you a examine for $10K as an angel investor, we’d like a shortcut. This is the reason early rounds often use a convertible notice or SAFE as a substitute.
What’s a Convertible Notice?
Reasonably than shopping for inventory from an early-stage startup, I hand them a examine and we name it a mortgage till the Collection A funding spherical. At the moment, my examine is utilized to buy the popular shares together with the opposite buyers. It’s like pre-purchasing shares.
Since I need to purchase fairness, why are we calling this a mortgage?
- To accountants (and the IRS), financing is both buy of fairness or a mortgage. Since I’m not shopping for fairness but, it needs to be a mortgage.
- Mortgage paperwork are easy. I provide you with cash, you conform to repay it by a sure date with curiosity. That’s it.
- A mortgage presents me some fundamental protections. Whereas I don’t have shareholder voting rights, you’ll be able to’t pay out shareholders with out paying me first.
The convertible promissory notice is a normal mortgage doc with a particular provision: when the corporate sells inventory to different buyers, the mortgage quantity is utilized to the acquisition of the inventory.
Legally it’s a mortgage. The paperwork says it’s a mortgage. The accountants put it on the books as a mortgage. The IRS considers it a mortgage (an issue we’ll get to later). It has a maturity date and an rate of interest like a mortgage. It’s not a mortgage.
Although it purports to be a mortgage, no startup within the historical past of startups has ever repaid it. In reality, a convertible notice features a provision that forestalls you from paying it again. Ignore what many of the doc says — it is a holding gadget to buy inventory.
The doc is barely 10–15 pages, most of that are irrelevant mortgage reimbursement particulars. You’ll be able to generate a convertible notice settlement on Cooley Go in a few minutes.
If I merely accepted no matter phrases you negotiate with the following spherical of buyers, the convertible notice can be trivially simple. However since I’m investing now whenever you’re simply getting began, I don’t need to pay the identical value as buyers in Collection A, which is perhaps years away.
If I believe your startup is value $10M now, I need to buy the inventory on the $10M valuation fairly than the $50M valuation you’ll have two years later. However in the event you do a funding spherical 6 months from now at $5M, then I need the $5M value. That is referred to as a valuation cap. I pay the negotiated Collection A value as much as the valuation restrict.
The opposite choice is a reduction on the valuation. A reduction alone could also be acceptable if the Collection A is imminent, however many buyers together with me gained’t spend money on a convertible notice and not using a valuation cap. A 20% low cost on the $50M valuation two years from now hardly compensates me for the danger I’m taking now.
As a result of the convertible notice is a mortgage, it has a maturity date and an rate of interest. Nonetheless, no funds are made. The complete quantity, together with accrued curiosity, is due at maturity, so there must be an fairness funding spherical previous to that deadline.
When you assume a convertible notice is an excessively difficult technique to pre-pay for inventory, you’re proper.
What’s a SAFE?
What buyers like me really need is an easy technique to buy fairness now whereas leaving the docs for later. So the oldsters at Y-Combinator invented the “Easy Settlement for Future Fairness”. The SAFE runs solely 7 pages and isn’t purported to be modified.
In contrast to a convertible notice which purports to be a mortgage, the SAFE states that it’s the buy of fairness. Whereas the IRS has not made a ruling, for the reason that SAFE is clearly not a mortgage, a robust case will be made that it should be fairness and subsequently eligible for the large tax advantages of buying fairness.
Like a convertible notice, the SAFE has both a valuation cap or a reduction, or the choice to take one of the best deal another investor negotiates. Because it’s not a mortgage, it has no maturity date and pays no curiosity.
The unique SAFE was nice for accelerators and startups, however for complicated causes I gained’t get into, it sucked for buyers and plenty of refused to make use of them. An up to date model referred to as the Submit-Cash SAFE corrected the problems and is gaining broad acceptance.
Tax Advantages of Investing in Startups
It’s inconceivable to know why buyers need most well-liked shares and not using a fast point out of tax legislation. I’m not a lawyer or an accountant, so I’ll maintain it easy.
The most important profit, and it’s insane, is that if I buy inventory in a startup and maintain it for at the very least 5 years, I pay NO federal earnings tax on the positive factors. NONE. Zero. Zilch.
However that 5-year clock is important. If the enterprise is acquired in 4 years and 11 months, I’ve to pay capital positive factors taxes (24%). If I maintain the inventory for lower than 1 yr, I’ve to pay full earnings tax (37%).
And if the corporate fails, like 90% of my investments will, I get to put in writing off the loss in opposition to earnings as a substitute of capital positive factors. Take my phrase that’s very helpful.
These advantages solely apply to fairness in a US-based C-Corp. They don’t apply to debt. Convertible notes solely depend as soon as the mortgage has transformed to inventory. And that’s a giant downside. The conversion must be fast.
The SAFE claims to be fairness and eligible for the tax advantages of buying fairness, however with out truly proudly owning fairness. The IRS has not dominated on the matter, leaving buyers on edge about how our SAFE investments can be taxed.
Understanding the Commerce-Offs
The selection between most well-liked fairness, convertible notice, and SAFE is a trade-off between simplicity, taxation, and management.
Fairness presents large advantages to buyers for taxation. SAFEs could supply the identical advantages, however no person is certain how the IRS will rule, so buyers are much more snug as soon as the SAFE has transformed to most well-liked fairness. Convertible notes are problematic for taxation, and we’ll demand as brief a maturity date as doable.
Management is the tough aspect to guage. A SAFE presents buyers no voting rights, no board seat, no oversight of the corporate. Positive for an accelerator investing in dozens of corporations per cohort, however not nice for angel buyers who need to do greater than hand over a examine and pray.
For the startup founder, no investor oversight could seem to be heaven. All I can say to that’s that if you wish to go it alone, that’s wonderful, however in the event you don’t need me to be a part of the corporate, don’t ask for my funding.
Convertible notes have a maturity date by which era the notice needs to be transformed to fairness. This units a deadline for getting the Collection A funding spherical accomplished. For tax causes, the investor will demand the maturity be as quickly as doable, sometimes 18–24 months.
Additional, convertible notes can specify some element of what should be included in the popular shares on conversion.
For these two causes, most buyers desire convertible notes over SAFEs, whereas some desire the doable tax advantages of SAFEs.
Which One to Select?
Sometimes, family and friends rounds are SAFEs, pre-seed and seed rounds are convertible notes, and collection A (by definition) is most well-liked fairness. Nonetheless, increasingly often, I’m seeing pre-seed and seed rounds additionally being raised on SAFEs.
When you’re opening a considerable spherical and anticipating giant enterprise capital funds to put in writing large checks, you gained’t have a alternative. They’ll require most well-liked shares and may have many calls for on the time period sheet. Time to rent good attorneys.
Within the early family and friends spherical, SAFE is an effective alternative. It’s easy for each events. You’ll be able to change the valuation cap as the corporate makes progress with out having to arrange a brand new funding spherical.
Pre-seed and Seed rounds are the place the trade-offs must be weighed.
Most popular fairness will take money and time to barter, and can seemingly embody a board seat and different investor protections. Whereas the trouble issue is increased, this makes the funding extra engaging to buyers. You might be able to entice extra buyers with most well-liked shares or negotiate a better valuation.
The convertible notice is easier and sooner than fairness and appears extra skilled than SAFEs. Convertible notes are acceptable to all angel buyers. Nonetheless, for the startup, it units a deadline for finishing Collection A which may trigger issues later.
SAFEs are less complicated and sooner than convertible notes and should supply tax advantages instantly. Nonetheless, SAFEs include no investor protections and no deadline for getting the actual inventory paperwork with investor protections. As well as, there may be nonetheless a stigma related to SAFEs because of the earlier pre-money model.
Consequently, some early-stage buyers desire convertible notes and a few desire SAFEs. Personally, if I’m investing by myself, I desire the simplicity of the SAFE. If I’m investing as a part of an angel group, the flexibility of the group to barter circumstances within the convertible notice makes it preferable if fairness just isn’t an choice.
For the founder, whether or not to decide on most well-liked fairness, convertible notice, or SAFE is determined by the scale of the spherical, confidence in elevating the following spherical rapidly, and the choice of potential buyers. Be sure that to decide on properly.
When you discovered this text useful, please depart a notice within the feedback. Listening to my article has been helpful is a lot extra worthwhile to me than the tiny quantity Medium pays. If I acquired something mistaken, corrections are appreciated, too.
Disclaimer: If it isn’t clear from the way in which I write, I’m not a lawyer. A lawyer’s job is to warn you of each doable danger. My job is to boil down the complexity to the stuff most individuals must know. That will or could not cowl the particulars of your state of affairs. As well as, I’ve spent my profession constructing startups fairly than learning tax legislation, so a few of this is perhaps mistaken. If that’s the case, I promise to return all 3 cents that I earned for writing this text (minus the $30 wire payment). Sorry, that’s the one assure you get. As at all times, do your personal diligence. As a founder (or investor) you might be solely accountable for your personal destiny.
An enormous thanks to grasp negotiator Doug Swets for sharing his unbelievable experience in startup financing to assist me write this text.