Comparing Convertible Instruments

November 15, 2022  |  By ,

In recent years, convertible instruments have become an increasingly more common method of financing for early-stage companies as an alternative to traditional equity financing. While they first became popular as a replacement to preferred stock offerings in seed rounds, we are now seeing them often used as “bridge rounds”—situations when a startup may need just a little more runway before they are ready for their Series A, Series B, or Series C raise. In 2021, the average convertible note round raised by VW clients totaled $1.1M and the average Safe round raised $960K. (You can see our full 2021 Venture Deals Report for more information.)

For context, convertible instruments come in a few different flavors:

These days we don’t see the Y-Combinator pre-money Safe as often as the post-money version, and we rarely see 500Startups’ KISS anymore. Thus, this post will focus on the key similarities and differences between convertible notes and post-money Safes. (We would like to take this opportunity to encourage everyone to use the YC post-money Safe, or something very close to it with the differences explained in the footnotes. Doing so greatly accelerates and facilitates early-stage venture financings. Not doing so can lead to conversion chaos when a financing round happens.)

If these concepts are new to you, it may be helpful to first review these primers on the basics of convertible notes and the mechanics of converting them into equity. YC has a great FAQ on Safes as well.

Similarities

There are many similarities between convertible notes and Safes.

  • They both delay the need for the investor and company to agree on a final valuation.
  • Both may be subject to a cap and/or discount.
  • They keep the early investors off the cap table for now – so there’s no need to include them in any stockholder consents.
  • They are quick and efficient. This helps to keep legal fees low.

Differences

There are some critical differences, however, which render Safes more company friendly, and convertible notes more investor friendly.

  • First of all, convertible notes accrue interest. This means that all other things being equal, a convertible note will end up converting into a few more shares than a Safe of the same investment amount would due to the accrued interest.
  • Convertible notes have a maturity date, and Safes do not. The maturity date acts as a fuse that forces some action by the company within a defined period with respect to an equity financing round.
  • Convertible notes typically have a “Qualified Financing Threshold,” which means that the company must raise an equity round of a certain size before the notes convert. Safes typically do not have a threshold and any sized preferred financing round will do.
  • Convertible notes are generally treated as debt, while Safes are not. This means that convertible notes are generally ahead of Safes in priority in the event of bankruptcy or liquidation. (In reality, this is a fact-specific matter).
  • The conversion mechanics of notes are not uniform like they are for post-money Safes (assuming everyone is using the YC post-money terms as they should be), and this can lead to confusion and difficulties when performing conversion calculations.

As an investor, on top of having an interest rate attached to your note, it can be more attractive to have the various other protections afforded by convertible notes—a maturity date, a Qualified Financing Threshold, and the classification of debt. As you may imagine, the actual agreement for a convertible note is longer and there are more negotiation points that investors and companies can go back and forth on. This leads to increased flexibility, particularly for larger investors that may sometimes be the only participant in the round. All this being said, and assuming you properly understand the differences in conversion mechanics, convertible notes are probably the preferred first option as an investor.

Contrast this with Safes: they are simple, (generally) standardized, and the fact that the terms are rarely changed can make them a much more attractive fundraising instrument for founders. There is no maturity date to negotiate, no Qualified Financing Threshold, and no interest rate—really, the two parties just need to agree upon an investment amount and a valuation cap or a discount. In turn, the founders can receive their funds and allocate them toward the company quicker, and may also save in legal fees. We have noticed that a lot of early-stage investors find this attractive as well.

In conclusion, whether you’re an investor or a founder looking to raise an early-stage round, it’s important to understand the nuances between convertible instruments before you get to the negotiation table.

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Posted in: Funding & Capital Raising

About the Author(s)

Kevin Vela

Kevin is the managing partner at Vela Wood. He focuses his practice in the areas of venture financing, M&A, fund representation, and gaming law.

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Bobby Gojuangco

Bobby Gojuangco is an attorney at Vela Wood. He focuses his practice in the areas of venture financing, M&A, and taxation.

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