When a startup raises money, it and the investor are faced with a decision: how exactly to formalise this investment. There are three common tools.

How exactly do investors put the money in startups?

Today, there are three popular mechanisms for investing in young technology companies that have proven their effectiveness.

• SAFE (Simple Agreement for Future Equity). The investor puts money now, but receives shares later, during the next round of funding.
• Convertible Note (convertible loan). Same thing, except the original money is treated as debt with interest.
• Priced equity round. A transaction with a clear valuation of the company and the purchase of a specific number of shares.

The form of investment depends on the stage of a startup's development, the amount, and the investment strategy of the fund or private investor.

What is SAFE?

When it comes to venture capital investment, especially in the early stages of a startup's development, traditional mechanisms such as direct equity acquisition often prove too complicated and time-consuming.

That is why the renowned startup accelerator Y Combinator offered a new tool — SAFE (Simple Agreement for Future Equity). It quickly became the standard for investing in early-stage companies in the US and then around the world.

In a nutshell, SAFE is a legal agreement between a startup and an investor whereby the investor gives money to the company but only receives equity in the next investment round.

With SAFE, the startup gets funding quickly, while the investor secures the right to a stake in the company in the future. Another advantage is that the formal issue of shares is also postponed to the future.

Important: SAFE is not debt (unlike convertible notes) and has no maturity or interest rate. It is a very simple and flexible instrument.

How does SAFE work?

The terms of a SAFE are very simple. The investor transfers money to the startup in exchange for the right to future shares and the terms on which those shares are granted (e.g. at a discount or a fixed maximum valuation).

The SAFE is converted into shares at the time of the next funding raise through the Priced Equity Round (i.e. when the value of the shares is determined), or sometimes when the company is sold.

The key parameters of the SAFE

Valuation cap

This is the maximum value of the company at which an investor can convert their money into shares.

For example, if the SAFE has a valuation cap of $5 mln and the next round values the company at $10 mln, the investor will still receive shares at the $5 mln valuation.

Discount

The SAFE may give the investor the right to buy shares at a discount in the next round.

Most Favoured Nation (MFN)

This gives the investor the right to switch to better terms if the startup offers them to other investors in the future.

Pro rata Rights

The SAFE may provide the right for the origin investors to participate in future financing rounds to maintain their stake in the company.

When is SAFE used?

SAFE is most commonly used when:

• Pre-Seed and Seed stage startups.
• Need to raise small amounts ($50,000 to $2-3 mln).
• The startup wants to close the round quickly.
• Raising bridge funding between larger rounds.

What are Convertible Notes?

Convertible notes (or loans) are a venture capital investment vehicle that combines the features of a debt obligation and future equity rights.

When an investor provides money to a startup through a convertible note, it is considered debt. However, under certain conditions, such as during the next funding round, the debt is converted into shares in the company.

Key features:

• Interest rate. Convertible notes typically charge interest, which increases the amount that is later converted into shares.
• Maturity. If conversion has not occurred by a certain date, the startup must return the money to the investor (or negotiate a change in terms).
• Valuation cap and discount. Like SAFE, Convertible Notes can include a valuation cap and discount on conversion, protecting the investor from excessive growth in the startup's value.

Convertible Notes are popular with early-stage startups because they allow them to raise funds quickly and defer complex valuation negotiations to the future.

What are Priced Equity Rounds?

A priced equity round is a classic form of early-stage investment, in which a company officially sells its shares to investors at a set price.

Unlike instruments such as SAFE or Convertible Notes, where the valuation of the company is deferred to the future, in a Priced Round everything is determined at once: what the company is worth, how much a share costs and how much each investor will receive.

How does a Priced Equity Round work?

• Company valuation. The startup and the investors agree on what the company is worth at the time the investment is raised. This is called a pre-money valuation.

• Signing of legal documents. Priced Round draws up full legal agreements outlining shareholder rights, dividend distribution terms, how shares will be sold, etc.

• Issue of new shares. After receiving the money, the startup officially issues new shares, which are transferred to investors in exchange for their money.

• Closing the deal and updating the capitalisation. The captable is adjusted to show the new owners and stakes in the company.

Why do companies choose Priced Equity Rounds?

A priced round is an important step in the development of a startup. It is typically chosen when:

• A large amount of money needs to be raised (several million dollars or more).
• The company already has a history of growth and a real value that can be estimated.
• Need to resolve legal issues, especially before a large follow-on financing or IPO.

Priced rounds give investors more protection as their rights are detailed. Safeguards can include liquidation preferences, voting rights and anti-dilution protection.

Comparison of SAFE, Convertible Notes and Priced Equity Rounds

Key differences between SAFE and Convertible Notes

Legal Structure and Repayment

• SAFE is not a debt instrument and has no maturity date. This reduces the legal complexity of the deal, as there is no need to set up a repayment mechanism.
• Convertible Notes are a debt instrument with a maturity date. If the startup fails to convert the investment into equity, it must be repaid.

Interest

• SAFE does not bear interest as it is not a debt.
• Convertible Notes often include interest that accrues on the amount invested. This gives the investor the added benefit of income.

Ease of agreement

• A SAFE is simple to conclude as it does not contain complex repayment, interest, or maturity terms.
• Convertible Notes have more legal requirements as they are a debt instrument. They require additional documentation and approvals, making the process more complicated.

Risks for the investor

• SAFE offers no guarantee of returns, so an investor could lose all their money if the startup is unsuccessful.
• Convertible notes offer additional protection to the investor in the form of an investment return right if the startup fails.

SAFE vs. priced equity rounds

Company valuation

• SAFE. The valuation of the startup is not determined at the time of the deal. This avoids complex negotiations and allows capital to be raised quickly.
• Priced Round. The valuation of the company is clearly defined at the time of investment. This allows investors to know how much they are getting for their money.

Risks for the investor

• SAFE. The investor has no guarantee of receiving shares in the future. If the startup fails to raise the next round of funding and convert the SAFE, the investment is burned.
• Priced round. The investor receives a clearly defined proportion of the company's shares and voting rights. In this case, the risk is reduced because the investor effectively becomes a co-owner of the company.

Simplicity and speed vs. transaction thoroughness

• As SAFE is a simplified model without the need to determine the valuation of the company, a deal can be completed in a matter of days at minimal cost.
• The process of raising funding through a Priced Round is much more complex. The valuation of the startup requires detailed analysis, and the legal documentation is more extensive and costly, which can take several months.

Investor Rights

• An investor making a deal through SAFE does not have the rights of a full co-owner of the company until their investment is converted into shares.
• In the case of a Priced Round, the investor immediately receives shareholder rights, which may include voting and dividend rights.

Flexibility for a startup

SAFE is more flexible because the valuation of the business is deferred until a later stage. This allows startups to focus on product and business development without wasting time and resources on complex negotiations.

In a priced round, the valuation of the company has to be determined at the beginning of the deal, which creates more legal and financial obligations for the company.

In summary, SAFE is an effective solution for an early-stage startup to raise money without pressure or unnecessary bureaucracy. For the investor, it is also a quick way to get involved in a potentially promising project.

At the same time, Priced Round is a tool for mature rounds with guarantees for investors and big cheques for startups.

Convertible Notes vs. Priced Equity Rounds

Company valuation

• Convertible Notes. Company valuation is usually deferred until a later stage. This allows startups to raise capital without having to determine it early.
• Priced round. The valuation of the company is determined at the very beginning. Investors have a clear understanding of what they are getting for their money.

Risks to the Investor

• Convertible Notes. The investment may be lost or may not yield the desired return if the company fails to complete the next round of financing or other event that allows the debt to be converted into equity.
• Priced round. The investor receives a well-defined stake in the company, which reduces the risk, as the investor becomes a shareholder with all the privileges.

Repayment and Maturity

• Convertible Notes have maturity dates (typically 18–24 months) after which the loan must be converted into shares. If this does not happen, the startup is in trouble.
• A priced equity round has no maturity date as it is not a loan but the sale of a stake in the company.

Legal complexity

• In general, convertible notes are much simpler because the transaction boils down to defining the terms of the conversion and the debt.
• A priced round, on the other hand, requires significantly more legal procedures, such as the preparation of the company's articles of association, shareholders' rights and other documents, making the process complex and costly.

The bottom line is that Convertible Notes are an effective bridge round and early stage tool due to their speed, conventional simplicity and additional investor protection.

Priced rounds are much more appropriate for conventional rounds, as they remove additional pressure on the startup while providing guarantees to investors.