Startup Lawyer Scott Smedresman on the Pros and Cons of Convertible Debt and SAFEs

When you’re raising early money, two common vehicles for your startup to use are convertible debt and SAFEs. And it’s important to understand the differences between the two so you can make an informed choice on the best option for your company.  Labs mentor Scott Smedresman, partner at McCarter & English, LLP, held a Labs session all about early-stage fundraising, including the important pros and cons of these two vehicles. Here are the basics.

Convertible Debt

Pro: You avoid having to figure out the details of preferred stock right now

“From the deals we see, most early-stage startups are doing convertible debt,” Smedresman says. “The general premise of convertible debt is that it’s too expensive and time consuming to do a priced equity round early on. As an early-stage startup, you don’t know what the company’s worth, and you don’t want to spend the time it takes to sort out the details of what preferred stock actually looks like.” (Preferred stock is stock that’s preferential to common stock, Smedresman explains, and it usually comes with control preferences over common stock and downside protections in case the company raises money later on at a lower price.)

“Early investors still expect this kind of preferential stock, but startups don’t want to figure that out. So how do you bridge that gap? The solution is convertible debt,” Smedresman says. “It’s structured as a loan, so it’s money for the startup now. But instead of repaying the loan in cash, you replay the loan in preferred stock when the preferred stock gets issued. As a startup, you give yourself between one and two years to get the preferred stock figured out. You just kicked the can down the road because by repaying the debt with that preferred stock,  investors get all those rights and preferences at that point. This solution solves everybody's problems: it gives the investors what they want and it gets your startup money now without having to spend all that money and time figuring out the preferred stock.”

Pro: It’s much cheaper to execute than a priced equity round

“If you’re hiring a sophisticated law firm to handle a priced equity round for you, which is recommended, it can cost you $20,000 to $40,000 because there’s a lot of work that goes into it,” Smedresman says. “Hiring a sophisticated law firm to handle a convertible debt round for you can cost $5,000 to $10,000. It can vary based on how many investors you have, how much money you’re raising, and how hard investors negotiate, but it’s a pretty accessible price.”

Plus, “when you’re raising less than $1M, it’s hard to justify spending $20,000 to $40,000 on legal fees, but spending $5,000 to $10,000 seems much more reasonable,” Smedresman says. But it still costs thousands of dollars because “even though you’re kicking the can on the fundamental business points of what it means to issue preferred stock, there are still other business points that need to be decided on when you’re crafting a convertible note round. For example, how long is the long outstanding for? What’s the interest rate? That gets issues in the form of additional shares, not cash, but it still needs to be figured out.

Con: You still have to mitigate the risk for early investors

“The interest rate on the loan is one to compensate for that risk,” Smedresman says, “and the typical interest rate on a convertible note is between four and eight percent. But that’s not a lot of upside for giving you that early money. So the other two ways to compensate for risk are a discount and a cap.”

“The basic premise of a discount is giving the investor a percentage off of the next round—the typical discount is 20 percent,” Smedresman says. “So if the next round is priced at $10 million pre-money, their money comes in at a resumed $8 million pre-money. The other typical method of risk compensation is a cap, or a maximum pre-money valuation. That means that no matter what your next round is priced at, their money comes in at a set valuation. So if you do your next round at $10 million but you gave the investor a $5 million cap, they’re effectively getting a 50 percent discount.”

“Now these aren’t things that the law says you have to include in your convertible debt round, but they’re market standards and investors expect them,” Smedresman says. “And even if investors don’t ask for them, my advice is not to get too aggressive on off-market terms of early investors. Because eventually they’ll realize they got a crummy deal and you won’t have happy investors once that happens. They end up with a good amount of control over your company, so don’t give them a raw deal without them knowing it.”

SAFE (simple agreement for future equity)

Pro: There’s no interest

“SAFEs operate very similarly to convertible debt expect that it’s not debt,” Smedresman says. “Convertible debt is structured as a loan, but a SAFE operates as equity— it doesn’t have to be repaid, it doesn’t have interest or maturity like debt does. It’s the best of both worlds for the startup. You get the money now and you give equity later. With convertible debt, if two years comes and goes and the debt needs to be repaid plus interest, that could create some pressure on the company to do financing before it’s ready. A SAFE doesn’t have that; it just sits there until one of these triggering events happens, like raising new money.”

Pro: They’re simple, quick, and comparatively cheap

With SAFEs, “there’s almost no legal cost because you’re basically pulling the template off the internet,” Smedresman says. “You can tweak it and make changes to it, but my general view is that the whole benefit of the SAFE is that you’re not making changes—it’s a template document. So you understand the pros and cons but you’re just going to go with it because there’s almost no cost to doing it. Then all you need is a basic board consent approving the issuance of these SAFEs and you’re done. It’s tremendously easy. If all you’re doing is pulling it off the internet and getting a lawyer to just look it over and draft Board of Directors consent documents, it’s less than $1,000. There could also be some post-close filing cost with the SEC, which is generally recommended.”

Con: Not all investors are on board with SAFEs

“Because SAFEs are so favorable to the startup, they’re less common than convertible debt,” Smedresman says. “There’s less in it for an investor. You see SAFEs being used in more company-friendly deals with less sophisticated investors. There are fewer barriers than there used to be in getting investors to use it, but, for example, VC funds are not really interested in investing with SAFEs.”

“The best use case we typically see for a SAFE is if you’re doing a friends and family or angel round,” Smedresman says. “These are situations where people aren’t negotiating heavily, they want to give the money to support the entrepreneur, but it’s not a gift. They do expect some type of return. They want a reasonable shake but they’re not going to be difficult about it. In that circumstance, the SAFE is fantastic.”

Learn more about fundraising and legal issues for early-stage startups.

This post is based on content from a WeWork Labs programming session.

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