Convertible Notes, SAFE Notes, and Revenue-Based Financing Explained (In Simple Language)

By Andrew Abouchar

Posted September 30, 2019

 

When the time comes for a SaaS company to raise some capital, there are many options available—each with its own set of jargon. While founders are often familiar with the various options, they may find it difficult to distinguish between them and decipher which one is right for the company and at what stage.

This post describes two early-stage financing alternatives in simple language—convertible notes and SAFE notes—and details the pros and cons associated with each.

It also describes a financing option for B2B SaaS companies that are a little further along the growth cycle (with approximately $1-20Million Annual Recurring Revenue)—revenue-based financing.

Photo by Manik Rathee on Unsplash

What is a Convertible Note?

A convertible note is unsecured debt that converts into equity when triggered by a subsequent equity fundraise. In the context of a seed financing, the debt usually converts into shares of preferred stock.

After a triggering event, shares are given a value that is the lower of:

  1. The price determined by dividing the cap by the number of shares outstanding; or
  2. The price of the shares issued by the triggering event (or at a discount price, depending on the terms of the convert)

Example 1
An investor buys a $500,000 convertible note with a cap of $5M, the estimated value of the company at the triggering event is $10M, and there are 7.5M shares outstanding immediately prior to the triggering event.

The shares would convert at the cap rather than the estimated value, since the estimated value is higher than the cap. In this case, the conversion price would be calculated as the cap divided by the number of shares outstanding: 66.67 cents/share ($5M/7.5M).

The investor would receive 749,625 shares ($500,000/66.67 cents/share).

Example 2
An investor buys a $500,000 convertible note with a cap of $5M, the estimated value of the company at the triggering event is $4M, and there are 7.5M shares outstanding immediately prior to the triggering event.

The shares would convert at the estimated value of the company at the triggering event rather than the cap, since the cap is higher than the estimated value. In this case, the conversion price would be calculated as the estimated value divided by the number of shares outstanding: 53.34 cents/share ($4M/7.5M).

The investor would receive 937,383 shares ($500,000/53.34 cents/share).

 

Pros

Cons

Fewer complications: Compared to typical priced rounds, convertible notes are faster, simpler, and cheaper. There is no need to create a second class of shares or issue common stock.

No pre-money valuation: Convertible notes allow issuers to defer valuation negotiations until a subsequent round of financing. This gives the company time to develop metrics which can be used to determine a fair price.

Investors can be wary: Some investors prefer to wait until a priced round (even though they will most likely pay a higher price). Early-stage investing is risky and the investor doesn’t really get paid for the risk if the instrument converts into the next round price.

Potential stakeholder misalignment: If convertible notes are uncapped, the interests of the issuer and the noteholders are not aligned when it comes to the valuation—issuers want the valuation to be as high as possible, while noteholders want the opposite.

Loss of equity: The founder loses a portion of shares when the note is converted.

 

What is a SAFE Note?

A SAFE (simple agreement for future equity) note is a simpler alternative to a convertible note, allowing startups to structure seed investments without interest rates or maturity dates. The note is not debt. It is simply a legal contract that allows the investor to buy shares at the lower of the valuation cap or the price of the future round. The valuation cap is the only negotiable detail.

Pros

Cons

Simplicity: At just 5 pages long, a SAFE note is simpler than a convertible note. It is straightforward with clear upsides and downsides.

Less to negotiate: Unlike other investments, SAFE notes do not require much negotiation.

Ease of accounting: Like other convertible securities, SAFE notes end up on a company’s capitalization table.

Flexibility for startups: The lack of pre-defined terms and maturity date gives the startup more freedom.

Incorporation requirement: A company must be incorporated to offer SAFE notes—many startups are limited companies.

Lack of familiarity: SAFE notes are relatively new, which means lawyers and investors have less experience with them.

Fair valuation expenses: SAFE notes may trigger the need for a fair valuation (409a). A company may need to allocate funds for this, leaving less available for product development.

No minimum requirement: There is no minimum requirement for an equity round to go into conversion.

Dilution: Many founders don’t think about the potential impact that these notes may have on the valuation of the business in the future.

 

Both convertible notes and SAFE notes are convertible securities, which means they can eventually be converted to equity, diluting the ownership of the company and ultimately costing the founder dearly in the long term.

Revenue-based financing, on the other hand, requires no equity conversion whatsoever. The startup gets the capital they need to grow while maintaining equity, ownership, and control of their business.

 


Convertible notes and SAFE notes can eventually be converted to equity, diluting the ownership of the company and ultimately costing the founder dearly in the long term. Revenue-based financing, on the other hand, requires no equity conversion whatsoever.


 

What is Revenue-Based Financing?

Revenue-based financing—also known as revenue financing—is a type of growth capital provided by TIMIA in exchange for a small percentage of future revenue. This gives founders access to cash without sacrificing any equity. The repayments end when the initial capital amount, plus a multiple is repaid.

TIMIA participates in the revenue until a predetermined amount is paid back. Unlike equity, you only ever pay that predetermined amount regardless of how successful your company is. With equity financing, the more successful you are, the more the equity financing costs you.

With revenue financing, because the repayments are tied to monthly revenue, increasing in strong revenue months and decreasing in low-revenue months, SaaS companies can focus on growth, rather than worrying about setting aside cash for capital repayments.

Since revenue-based financing is tied to recurring revenue, it is generally considered at a slightly later stage than a convertible or SAFE note.

Pros

Cons

Founders maintain equity: TIMIA won’t ask for equity in your company or require personal guarantees.

Simplicity: No long drawn out processes. Our application process is simple and our contracts are quick and easy.

Speed: >Get up to $4M in growth funding within 4-6 weeks.

Ease of accounting: No embedded equity option to be valued for GAAP financial statements.

Flexibility for startups: Pay based on monthly cash flow. Repayments scale up or down based on your net monthly revenue. No hefty bill on a down month.

Limited to B2B SaaS companies: You must be a SaaS-based company located in the U.S. or Canada.

MRR is required: You must be generating revenue >$120K MRR.

 

Comparing Revenue-Based Financing to Convertible Notes and SAFE Notes

 

Convertible NoteSAFE NoteRevenue-Based Financing
Nature of obligationDebtWarrant/Convertible securityDebt
Eligible companiesLimited liability company or a C-corporationC-corporation onlyWorks best with a C-corporation
Interest rateYes, usually 2 to 8%, with an average of 5% in practiceNoYes, generally revenue financing works out at half the true cost of equity financing
Equity cededYesYesNo
DilutiveYesYesNo
Maturity dateYes, once the maturity date is reached the company must pay back the principal plus the interest or convert the debt into equity and issue shares to the investorNoYes, long term debt
Valuation capYesYesNot applicable
Event triggering the conversionA a current or future/next financing round or the sale of the company, or upon agreement between the partiesA future/next financing roundNot applicable
Early exitPossible to include a payout in case of change of control: 2x payoutPossible to include a payout in case of change of control: 1x payout or conversion into shares at the cap amount to participate in the buyout can be providedPossible for early exit companies to obtain a discount on total payments

 


 

Looking for non-dilutive capital?

TIMIA Capital works with B2B SaaS companies between $2 – $20million ARR.

Learn more

 


 

Andrew Abouchar

Andrew has 20-plus years of experience in Canada’s venture capital and private equity industry. He is a cofounder and partner in Tech Capital Partners Inc, a Waterloo-based venture capital management company and founder of TCP Property Inc, a private real estate fund. Earlier in his career, Abouchar worked as an accountant at PwC and as an investment manager at Working Ventures. His also an advisor to the Government of Canada and Province of Ontario, and currently serves on the board of Ontario Centres of Excellence.

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