Convertible securities, including both convertible notes and SAFEs, have become extremely popular in the startup financing world. I have invested in many dozens of these securities and find myself having similar conversations with Founders and other angel investors about various conversion scenarios and associated investment terms. I’m documenting my thoughts here as a reference point for others who may be thinking about this for the first time.

Note: I’m only focusing on conversion scenarios in this post (i.e., when will this convertible security convert into equity?)

Preamble: why use a convertible security?

The main reasons to use a convertible security are to simplify the financing and to defer material conversations about valuation to a later date. This can benefit both the Founder as well as the investor. That said, the ultimate objective in most cases is for the convertible security to convert into equity in the company via one of the scenarios described below. In the startup world, it is rare for convertible securities to simply be paid back (with interest in the case of a convertible note). The reason for this is that startups are very risky investments where the default outcome will be 100% loss of capital, so an upside of repaid principle + interest is not commensurate with the risk being taken.

Note: while convertible securities have benefits, it can also be beneficial to establish a valuation and raise a priced equity round (for example, starting the 5 year holding requirement for Section 1202 / Qualified Small Business Stock).

Scenario #1: company raises qualified equity financing

In this scenario, the company raises additional financing – typically from new investors but not always – in a qualified priced equity round and your convertible security converts into equity in this new round. This is the main scenario both Founders and investors are expecting when they do the original convertible security investment.

The amount of equity you receive depends on the valuation of the new priced equity round and the valuation cap & discount rate of your convertible security. One thing I’ve learned is that this conversion math is complex & often wrong on first pass, and you should always verify it with your advisor. The equity you receive will have the same terms as the investors in the new financing – typically preferred stock with a liquidation preference and various protective provisions.

A few details to note:

• The investment docs in your original convertible investment will typically refer to this financing as a Qualified Financing and include a minimum amount, say $2 million. The purpose of this minimum is to protect investors in the convertible security against a Founder raising a “fake” investment round for the sole purpose of converting outstanding convertible securities on non-market terms (for example, at a ridiculous valuation). If the company raises a priced round financing below the Qualified Financing threshold, typically investors are given the option to convert or not.
• You may notice that some of the equity you receive after conversion is referred to as a shadow class of shares. The reason for this is to prevent convertible security investors from receiving a liquidation preference greater than the new priced round investors. For example, if you invest $50,000 in a convertible security with a Valuation Cap of $5 million, and the valuation in the next priced round is $50 million, then you are going to convert into equity at a price per share considerably below what new investors are paying. As a result of that, you would end up with a liquidation preference of much higher than your original $50,000 investment. The shadow class of shares insures you receive the appropriate number of shares but only a liquidation preference of $50,000 as intended. (Mark Suster wrote about this topic in 2015 and his suggested solution has become common.)

Scenario #2: no qualified equity financing prior to maturity date

In this scenario, the company fails to raise – or decides not to raise – a subsequent qualified priced equity round. This is not the desired outcome for either Founders or investors, but it is common and thus important to understand and plan for.

With a SAFE, there is no maturity date at all. Thus there is nothing for Founders or investors to do until either scenario #1 or scenario #3 occurs. In the rare case a company decides not to raise a qualified priced equity round, but doesn’t plan to dissolve or exit soon, then Founders and investors can mutually agree to convert the SAFE into equity.

With a convertible note, the defined maturity date acts as a forcing function which can give investors leverage. What happens at the maturity date depends on the specific terms of the convertible note. There can be a lot of variance in these details which makes it important for Founders and investors to understand them at the time of the original investment. Common terms upon maturity would be for investors to have the option, but not the requirement, to convert into equity at specified terms.

A few details to note:

• The conversion at maturity can be automatic instead of at the investor’s discretion. This is generally not beneficial to either the Founder or investors.
• If the company still plans to raise a priced equity round in the future, it’s common for the Founder and investors to mutually agree to extend the maturity date for some period of time.
• The optional conversion may require >50% approval of the convertible note investors (by invested capital, not count). In this case, each individual convertible note investor does not get their own option. This is why it can be important to understand who the other investors are at the time you are investing.
• Ideally, the terms of the conversion would be pre-determined in the investment documents, including both the valuation cap at which the conversion will occur as well as the type of stock received in the conversion. However, defining these terms may contradict the purpose of using a convertible note in the first place, and thus the investment documents may be silent on one (or both) of these variables. In that case, the Founder and investors need to mutually agree on those terms. The language I like to have as an investor is the option to convert into equity at the defined Valuation Cap (or possibly even a lower value) and to receive preferred stock with rights and preferences consistent with the Series Seed financing documents.

Scenario #3: company is acquired

In this scenario, the company is acquired prior to raising a priced equity round. This scenario is less common and will generally be an acqui-hire or modest outcome. However, outliers do occur and the terms around this scenario can be extremely important in those outliers.

The most important aspect of this scenario is that the convertible security investor should get their choice between: a) getting their principle back, possibly with a multiple, + interest earned, or b) converting into equity and getting their pro rata portion of the exit proceeds. The latter is what gives the investor upside in outlier outcomes and should be considered a “must-have” investment term.

A few details to note:

• SAFEs should include this option because it is part of the document template.
• Convertible notes may or may not include this option, but you should require it in order to invest. Not having this option could mean getting only your money back despite the company selling for a large premium.
• SAFEs will typically only include 1x money back in the first option, whereas this term is negotiable in convertible notes. In my opinion, it’s reasonable for angel investors to expect a premium (1.5x or 2.0x) if the company decides to sell rather than raise a priced equity round and continue building the company.

Convertible Note vs. SAFE

This is an age-old debate in startup world and one that will not be “solved” in this post. Rather, I will share a few observations I think other investors, especially angel investors, may find value in:

• I greatly prefer SAFEs in some circumstances and convertible notes in others (i.e. this should be situation-dependent rather than a binary preference).
• Convertible notes are great when the company has tangible assets (e.g. equipment, IP, etc.) and investors want to secure claims on those assets.
• Post-money SAFEs are great for very early stage software companies where the benefits of convertible notes are unlikely to matter.
• Convertible notes have several potential benefits: 1) an interest rate that boosts return; 2) a negotiable change of control multiple in an early exit; 3) stronger Representations and Warranties from the company; 4) stronger claims against assets in a dissolution; and 5) most importantly a maturity date that acts as a forcing function and gives the investor leverage.
• The definition of Fully Diluted Capitalization is very important along with the Valuation Cap in determining how much equity you will get post-conversion. Generally, with a post-money SAFE you will not be diluted by any other convertible security whereas with a convertible note you will. Based on this, I generally prefer using post-money SAFEs except for scenarios where the benefits of convertible notes outweigh the anti-dilution protection of post-money SAFEs.