Negotiating SAFEs and Convertible Notes: Legal Tips for Founders
Securing early-stage financing is a critical milestone for any startup. Two of the most popular instruments used to raise capital at this stage are Simple Agreements for Future Equity (SAFEs) and Convertible Notes. These tools offer flexibility and speed, making them attractive for both founders and investors. However, their apparent simplicity can obscure significant legal and financial implications. For startup founders, understanding the key legal terms and negotiation strategies is essential.
Understanding SAFEs and Convertible Notes
What is a SAFE?
A SAFE is a financing contract that allows investors to convert their investment into equity at a later valuation event, typically a priced round. Introduced by Y Combinator in 2013, SAFEs are not debt instruments and carry no interest rate or maturity date. They are widely used for their simplicity and founder-friendly terms.
What is a Convertible Note?
A Convertible Note is a hybrid instrument, functioning initially as a loan that converts into equity upon a future financing round. Unlike SAFEs, convertible notes typically include interest rates and maturity dates, which can add pressure on startups to raise additional funds or convert within a set timeframe.
Key Legal Terms to Negotiate
1. Valuation Cap
The valuation cap sets the maximum company valuation at which the investment will convert into equity. A lower cap is generally more favorable to the investor, while founders should aim for a cap that fairly reflects their startup’s potential.
2. Discount Rate
This is the percentage reduction an investor receives on the share price during the conversion. It compensates early investors for the risk they assumed. Negotiating a reasonable discount rate (typically between 10-25%) is crucial.
3. Maturity Date (Convertible Notes Only)
Founders should be cautious with maturity dates, which can force repayment or conversion if a qualifying round hasn’t occurred. It's vital to negotiate flexible terms or extensions if necessary.
4. Interest Rate (Convertible Notes Only)
The interest on a convertible note accrues until conversion. Standard rates range from 4% to 8%. Excessive rates can dilute founders upon conversion, so it’s important to negotiate terms that balance risk and equity preservation.
5. Most Favored Nation (MFN) Clauses
MFN clauses allow investors to adopt better terms if offered to subsequent investors. While attractive to investors, they can complicate future fundraising rounds. Consider limiting the scope or duration of MFN provisions.
Legal Considerations and Risks
1. Dilution Impact
Founders must model various scenarios to understand the dilution effects of SAFEs and convertible notes, especially when multiple instruments are outstanding. Legal counsel can help evaluate the long-term equity impact.
2. Stacking Instruments
Combining SAFEs and convertible notes can complicate your capitalization table. Legal guidance is essential to maintain clarity and ensure fairness across funding rounds.
3. Trigger Events and Automatic Conversion
Clear definitions of trigger events, such as qualified financing, change of control, or IPO, should be included. Ambiguities can lead to disputes or forced conversions under unfavorable terms.
4. State Law and Jurisdiction
Each agreement should specify the governing law and jurisdiction for resolving disputes. Choosing a founder-friendly legal environment, such as Delaware, can provide predictability and reduce litigation risk.
Best Practices for Founders
Seek Legal Review: Never sign a SAFE or convertible note without professional legal review. Terms that seem benign may have hidden consequences.
Use Standardized Documents: When possible, use vetted templates such as the Y Combinator SAFE. However, even standard documents may require customization.
Educate Yourself and Your Team: Founders should fully understand the instruments they are using. Consider workshops, legal briefings, or consultations to ensure alignment among all stakeholders.
Maintain Transparent Cap Tables: Regularly update and share your cap table with key stakeholders to build trust and facilitate future investment.
While SAFEs and convertible notes can provide vital capital to fuel early growth, they are not without complexity. Strategic negotiation and sound legal advice are paramount to ensure these tools serve your long-term interests. Missteps can lead to unintended dilution, investor disputes, and operational challenges down the line.
For Miami-based startups or founders seeking experienced legal counsel to navigate early-stage financing, contact our firm at 786.461.1617 for a personalized consultation. Our attorneys specialize in startup financing and can help you negotiate and structure SAFEs and convertible notes in alignment with your strategic goals