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Alternative Investment Instruments for Startup Financing: Convertible Loans and SAFEs
Startup financing arrangements can be structured in many ways. The most common practice is a priced round, where the investor receives shares in the target company in exchange for their cash investment. However, a priced round is not always possible or the best option. In such situations, alternative financing instruments such as convertible loans or SAFEs (primarily used in the United States) can be utilized.
Convertible Loan
A convertible loan is a loan granted by an investor to the target company, which is typically later converted into shares of the target company at a discounted price. The conversion usually occurs in connection with the next priced round or the sale or listing of the company. Although it is a loan, it is generally not intended to be repaid.
A convertible loan agreement typically defines the loan amount, interest rate, maturity date, valuation cap, and conversion discount.
Key points about convertible loans:
- Common bridge financing instrument
- Convertible loans are often used for bridge financing between priced rounds.
- Convertible loan has investor protection
- If the target company does not succeed, the convertible loan investor can demand repayment of the loan and holds creditor status in a liquidation situation.
A convertible loan can also be structured as a capital loan (Finnish Companies Act, Chapter 12), in which case the loan can only be repaid when the provisions of the Finnish Companies Act regarding capital loans are met. A capital loan is also subordinated to the target company’s other debts. A convertible loan with capital loan terms can, in certain situations, be presented as an equity-like item and may improve the company’s solvency.
SAFE
A ‘SAFE” or Simple Agreement for Future Equity is an agreement between an investor and the target company, under which the investor receives shares in the target company at a discounted price at a later date. Unlike a convertible loan, a SAFE does not include interest or a maturity date, and it is not repaid in cash.
A SAFE agreement defines the investment amount, valuation cap, conversion discount, and the timing of share issuance (typically a priced round or the sale or listing of the target company).
Key points about SAFEs:
- Target company-friendly
- A SAFE is seen as advantageous for the target company because it does not include interest or a maturity date, and it is quick to execute.
- SAFE investors have minimal protection
- SAFE investors generally have no protection in a liquidation situation.
The use of SAFEs is popular in the United States for financing very early-stage companies (pre-seed and seed) due to their simplicity and the current standardized template. In Finland, SAFEs are not widely used due to, among other things, their ambiguity and potentially unfavorable interpretation from the perspectives of the Finnish Companies Act, accounting, and taxation.
Similarities between Convertible Loans and SAFEs
Fast and flexible financing
- Both instruments enable rapid financing without valuation of the target company or extensive negotiations.
Investor gains access to the company
- The investor can monitor the target company more closely before a potential follow-on investment.
- The success of the target company is in the investor’s interest, so they have an incentive to support the target company more closely.
Investors receive a discount
- Convertible loan and SAFE investors typically receive a discount on the target company’s shares upon conversion (this is a ‘reward’ for investing in the target company earlier).
Founders’ ownership may be diluted unexpectedly
- Multiple simultaneous convertible loans or SAFE agreements with varying terms can lead to uncertainty in the ownership structure and significantly dilute the founders’ ownership upon conversion.
Selecting the right financing instrument requires careful consideration, and in this context, it is advisable to ensure that:
- The parties have a shared vision of the company’s future,
- The investment documentation is clear, and
- The parties understand what the instrument and its terms mean for the ownership structure both at that time and in future financing rounds.