We break down the differences between convertible notes, SAFEs and KISSes
What is a convertible note?
A convertible note is a short-term debt vehicle that startup companies often use to raise funds before their first institutional round of fundraising.
These notes carries an interest rate and a maturity date and allow the investor to convert (hence the name) the note into equity — usually when a company consummates the next round of funding — anytime prior to the maturity date.
What are SAFEs/KISSes and why were they created?
SAFEs/KISSes are investment vehicles that were created as an alternative to convertible notes. Their purpose is to simplify the seed investment round, as well remove certain regulatory and insolvency risks that can be involved with the issuing of convertible notes.
By simplifying the investment documents, SAFEs/KISSes can save startups — and investors — time and money that would otherwise be spent on legal fees and the negotiating of complex terms. In practice, this should allow for a quick and efficient way to raise funds at the very early stage of a company, which is when they are needed the most.
SAFEs — The SAFE (Simple Agreement for Future Equity) was created by YCombinator in 2013. A SAFE would be referenced on the company’s cap table like a warrant or option, and is meant to be converted to preferred stock in a future fundraising round.
In an effort to avoid complexities in the agreements, YCombinator created four separate contracts to deal with different forms of SAFEs:
KISSes — The KISS(Keep It Simple Securities) was created with the same idea in mind by 500Startups in 2015.
KISS investors also receive a ‘most-favored nation’ term. If the company issues a better security in the future, then the KISS investors can covert their security to those terms instead. This is beneficial if a company does a ‘down round’ sometime in the future.
Unlike a SAFE, there are two types of KISSes:
- Debt Version: Interest Rate & Maturity
- Equity Version: No Interest Rate, No Repayment — however, there is still a maturity date.
Interest Rate & Maturity Date
Convertible Notes: As a debt instrument, all convertible notes will have an interest rate and a maturity date.
In theory, if the company does not consummate an equity raise prior to the maturity date of the convertible note, then the investor is owed their principal funds, as well as any accrued interest.
However, this is usually not what the investor or the company wants. The investor did not buy the convertible note for the interest rate payment (usually between 2–8% annually), and the repayment of the note with interest would be than likely bankrupt the company.
For this reason, some convertible notes are now drafted with an automatic conversion provision at the time of maturity. However, this also has its problems because you’ll either have to convert the notes into common stock (which the investors don’t want) or create a new type of preferred stock.
In this scenario, the easiest option is usually to extend the maturity date, which can be done with consent of a majority of the investors.
SAFEs: A SAFE is not a debt instrument like a convertible note, so it would not carry a maturity date or interest rate. Instead, this instrument would show up on the company’s capitalization table like warrants and options.
This lack of an interest rate and a maturity date are important for a few reasons:
- No Interest Rate — If the raise takes a long time to consummate, the investor would be left loaning money for an extended period of time without receiving any accrued interest.
- No Maturity Date — The investor runs the risk of their funds being held indefinitely, without a triggering event occurring that would convert the SAFE to equity.
KISS — Equity Version: As an equity instrument, there is no interest paid in this version. At maturity, it is converted to series seed preferred stock at the cap price.
KISS — Debt Version: As structured by 500Startups, this version carries an interest rate of 5% annually and maturity of 18 months. At maturity, a holder of the debt instrument has the option of converting to series seed preferred stock at the cap (most likely outcome) or being repaid their principal and accrued interest.
Discount Rate & Valuation Cap
The discount rate represents the discount that will be received relative to the other investors in the the subsequent financing round. This discount rate is used to compensate the early investors for the additional risk that they take to fund the business at a less mature stage.
Similarly, the valuation cap is put in as a reward for the risk that the earlier investors bore. This provision caps the share price at which a note can be converted into equity, thus giving the early debt investors an equity-like upside from the moment that they invest in the company.
Convertible Notes: Convertible notes may come with or without a valuation cap or discount, varying on a deal-by-deal basis. However, it is common for convertible notes these days include both.
SAFEs: SAFEs carry a discount rate similar to convertible notes. Not all SAFEs carry a valuation cap but it is something that investors would want to request when structuring this type of investment.
If the pre-money valuation of the company in the equity financing is lower than the valuation cap of the SAFE than the cap in inapplicable. In this case, the investor would get the same preferred stock as all of the other investors.
KISSes: The discount rate and valuation caps for KISSes are negotiated on a deal-by-deal basis.
How will these vehicles convert into equity during an equity financing round?
Convertible Notes: If the company consummates an equity raise prior to the maturity date of the convertible note, then the investor’s principal, together with all accrued but unpaid interest, will be converted into shares of the preferred stock raised by the company.
SAFEs: The SAFE will automatically convert to shares of preferred stock during the next round of fundraising without a threshold amount that needs to be raised to trigger the conversion.
The preferred stock that the SAFE converts to will be a separate series of preferred stock than the equity financing round, but will have the same rights, privileges, preferences and obligations as the equity financing round preferred stock. However, the liquidation preference, conversion price, and dividend rate will be determined by the price per share of the SAFE preferred stock series. (More details can be found in Ycombinator’s SAFE Primer – Appendix II, here)
KISSes: The KISS will automatically convert into preferred stock when the company raises a qualifying priced round of at least $1mm of new money.
The conversion price will be the lesser of the cap or discount. 500Startup created their instrument to be founder friendly, and as such, they don’t think that the investors deserve any additional liquidity preference on top of the cap/discount, which is negotiated on a deal-by-deal basis.
What happens in the case of an early exit/acquisition?
Convertible Notes: The most common scenario is for the investor to get repaid at premium, ranging from 0.5x to 3.0x (principal + interest + premium). The premium repayment allows the investor to get rewarded for the assumed risk in their early-stage investment.
However, depending on the structure, the investor could also negotiate equity conversion terms that are triggered upon the acquisition of a company prior to the qualifying financing round. In this case, the principal and accrued, unpaid interest would convert to equity.
SAFEs: If the company changes control before a financing round, then the SAFE holder has the right to either convert the SAFE into shares of common stock based on the valuation cap or have its investment returned.
KISSes: The investors would have the option to convert to common stock at the cap or get paid a multiple on the original investment. Their suggestion is that this should be a 2x multiple in order to make sure that an investor in this business scenario reaps some reward.
Summary
Convertible notes are still the most common instrument used by companies looking to for initial investors, but it is important to know about SAFEs and KISSes, in order to make an informed decision about what instrument is best for your business.
No matter how you decide to raise funds, we always advise you to have a lawyer look over these documents and provide their opinion on the instrument being used.
Lanyap Financial is a tech-based accounting and financial services firm that specializes in streamlining their clients’ financial operations through FinTech software and cloud-based applications.