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 $1-20 million in annual recurring revenue.
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:
- The price determined by dividing the cap by the number of shares outstanding; or
- The price of the shares issued by the triggering event (or at a discount price, depending on the terms of the convert)
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).
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).
|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.
|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 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.
Since revenue-based financing is tied to recurring revenue, it is generally considered at a slightly later stage than a convertible or SAFE note. However, if your business grows really quickly, revenue-based financing payments can escalate quickly, removing much-needed working capital from the business.
|Founders maintain equity as RBF generally doesn’t take any stake in the business.
Ease of accounting — no embedded equity option to be valued for GAAP financial statements.
Flexibility for startups as payments are based on monthly cash flow so there’s no hefty bill on a down month.
|MRR is required — you must be generating revenue >$120K MRR.
RBF can be detrimental to your business if you grow too quickly as payments become heavy in strong revenue months, taking working capital from the business.
Comparing Revenue-Based Financing to Convertible Notes and SAFE Notes
|Nature of obligation
|Limited liability company or a C-corporation
|Works best with a C-corporation
|Yes, usually 2 to 8%, with an average of 5% in practice
|Yes, generally revenue financing works out at half the true cost of equity financing
|Yes, 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 investor
|Yes, long term debt
|Event triggering the conversion
|A a current or future/next financing round or the sale of the company, or upon agreement between the parties
|A future/next financing round
|Possible to include a payout in case of change of control: 2x payout
|Possible 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 provided
|Possible for early exit companies to obtain a discount on total payments
Looking for non-dilutive capital?
TIMIA Capital works with recurring revenue technology
businesses between $2 – $20 million ARR.