Almost all start-ups will need to consider raising capital to support turning their concepts into a functioning product or service business. To help with their capital raise, founders turn to investors to request that capital in exchange for equity to support them on their quest.
There are two key ways that startups can do this which is to either issue shares (equity) in exchange for the capital upfront (in a priced round), or by using ‘convertible debt’ - typically in the form of Convertible or Simple Agreement for Future Equity (SAFE) notes. We’ve found a good article that details the differences between convertible and SAFE notes in New Zealand from our friends at LegalVision.
Why use Convertible or SAFE notes?
Both a Convertible note and a SAFE note are short-term debt that will eventually convert to equity, and it can have a few main advantages for a startup:
Quick to process
A startup can complete a convertible note transaction in a matter of days, and takes much less time from lawyers to process.
No sharing of control
Control rights are very uncommon with convertible and SAFE notes meaning that you do not have to grant rights to control certain aspects of your business such as a board seat or veto rights.
Delay valuing the startup
It can be difficult to value a business at the start of their lifecycle as there is little data to go off. Convertible (and SAFE) notes can be a good way to avoid this task until the next official pricing round. The benefit to the note investor is receiving a discount to whatever the priced round valuation will be.
SAFE notes do not have a return
They do not have a term associated with the debt, and don’t typically incur any interest.
How to model the dilution of Convertible or SAFE notes
A lot of startups are unsure whether using a Convertible or SAFE note is right for their business, and part of this may be due to not understanding how costly they are. By issuing these types of instruments, a company will permanently give some of their equity away which can be more difficult to estimate the cost of equity vs debt. Variables such as a future valuation discount, valuation cap, coupon (ie. interest rate, where applicable) and not having a set valuation, does make it a bit more tricky to work out what the outcome (dilution to existing owners) of the Convertible or SAFE note may be.
The team at Orchestra have come up with a helpful Convertible or SAFE Note Dilution Calculator to help startups determine whether this could be a viable option to inject more capital into their business.