Houston startup adviser on navigating SAFE, convertible notes in funding rounds
guest column
As both a founder and occasional early-stage investor in the Houston ecosystem, I've seen firsthand the opportunities and challenges surrounding seed funding for local startups. This critical first fundraising round sets the trajectory, but navigating the landscape can be tricky, especially for first time founders who may not be familiar with the lingo.
One key dynamic is choosing the right deal structure — SAFEs (Simple Agreement for Future Equity) vs. convertible notes are the most common vehicles early stage startups use to raise capital and are far more founder-friendly than a priced round.
Let's start first with what the have in common:
- Both allow you to defer setting a valuation for your company until a later (likely priced) round, which is useful in early stages or pre-revenue companies
- Both are cheaper and faster to execute than a priced round, which cash-strapped early stage founders like
- Both can have terms like valuation cap, discount, conversion event, and pro rata rights.
- Both are less attractive to investors seeking immediate equity (especially important if starting the QSBS clock is part of your investors strategy or if the investor is newer to startup investing)
- Both can create messy cap tables and the potential for a lot of dilution for the founders (and investors) if they are used for multiple raises (especially with different terms)
While as you can see they have similarities, they have some important differences. Let's dig in on these next:
SAFEs:
- Created by Y Combinator in 2013, the intent was to create a simplified, founder friendly agreement as an alternative to the convertible note
- Is an agreement for future equity for the investor at a conversion event (priced round or liquidation event) which converts automatically.
- It's not a debt instrument and does not accrue interest or have a maturity date.
- Generally have much lower upfront legal costs and faster to execute
Convertible Notes:
- A debt agreement that converts to equity at a later date (or conversion event like a priced round)
- Accrues interest (usually 2 to 8 percent) and has a maturity date by which the note must either be repaid or convert to equity. If you reach your maturity date before raising a qualifying round, you can often renegotiate to extend the maturity date or convert the note, though be prepared to agree to higher interest rates, additional warrants, or more favorable conversion terms.
- More complex and take longer to finalize due to non-standard terms resulting in higher legal and administrative costs
It's worth reiterating that in both cases, raising multiple rounds can lead to headaches in the form of complex cap tables, lots of dilution, and higher legal expenses to determine conversion terms. If your rounds have different terms on discounts and valuation caps (likely) it can cause confusion around equity and cap table structure, and leave you (the founder) not sure how much equity you will have until the conversion occurs.
In my last startup, our legal counsel — one of the big dogs in this space for what it's worth — strongly advised us to only do one SAFE round to prevent this.
Why do some investors tend to prefer convertible notes?
There are a few reasons why some investors, particularly angel investors from developing startup ecosystems (like Houston), prefer convertible notes to SAFEs.
- Because they are structured as debt, note holders have a higher priority than equity investors in recovering their investment if the company fails or is liquidated. This means they would get paid after other creditors (like loans or credit cards) but before equity investors, increasing the likelihood of getting some of their money back.
- The interest terms protect investors if the founder takes a long time to raise a priced funding round. As time passes, interest accumulates, increasing the investor's potential return. This usually results in the investor receiving a larger equity stake when the note converts. However, if the investor chooses to call in the note instead, the accrued interest would increase the amount of money owed, similar to a traditional loan
- More defined conversion triggers (including a maturity date) gives investors more control and transparency on when and how their investment will convert.
- Can negotiate more favorable terms than the standard SAFE agreement, including having both a valuation cap and a discount (uncommon on a SAFE, which usually only has one or the other), interest rates, and amendment clauses to protect them from term revisions on earlier investors by future investors (called a cram-down), etc.
We'll go over what the various terms in these agreements are and what to look out for in a future article
How to choose:
- Consider your startup's stage and valuation certainty — really uncertain or super early? Either of these instruments are preferable to a priced round as you can defer the valuation discussion
- Assess investor preferences in your network — often the deciding factor if you don't have a lot of leverage; most local angels prefer c-notes because they see them as less risky though SAFEs are becoming more common with investors in tech hubs like Silicon Valley
- Evaluate your timeline and budget for legal costs — as I mentioned, SAFEs are way less expensive to execute (though still be prepared to spend some cash).
- Align the vehicle with your specific goals and growth trajectory
There's no one-size-fits-all solution, so it's crucial to weigh these factors carefully.
The meanings of these round terms like "seed" are flexible, and the average seed funding amount has increased significantly over the past decade, reaching $3.5 million as of January 2024. This trend underscores the importance of choosing the right funding vehicle and approach.
Looking ahead, I'm bullish on Houston's growing startup ecosystem flourishing further. Expect more capital formation from recycled wins, especially once recently minted unicorns like High Radius, Cart.com, Solugen, and Axiom Space exit and infuse the ecosystem with fresh and hungry angels, new platforms beyond traditional venture models, and evolving founder demographics bringing fresh perspectives.
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Adrianne Stone is the principal product manager at Big Cartel and the founder of Bayou City Startups, a monthly happy hour organizer. This article original ran on LinkedIn.
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A Momentum class in session. Photo courtesy of EO Houston
