There are 3 main investment instruments used during pre-seed, seed and series A rounds: the traditional Convertible Notes (“CNs”), the SAFE and the KISS.
The ABCs of these investment instruments that you should understand is that all three of them are different types of convertible securities, with subtle but important differences.
CNs are the oldest and less sophisticated type of security used. They are quite simple to understand and apply, but as the VC industry matured, new ways to reduce risk and transaction costs were introduced.
YCombinator developed the SAFE (Simple Agreement for Future Equity) and 500 Startups created the KISS (Keep It Simple Security).
Let’s start with the 2 things what makes these instruments similar:
As they represent an agreement between an investor and a company, in essence, the agreements constitute a loan of money from the investor into the company.
But unlike a loan, this flow won’t come back as the invested capital plus interest, but as a part of the company’s shares. The money loaned is converted into equity. Hence, the name.
And in all cases, this conversion will take place after a certain event occurs (usually, the next fundraising round). We will talk more about this in a few moments.
Any founder and any investor will be thinking about how much equity will their investment represent in the future. Injecting $10.000 for 10%, 30% or 90% of the company is not the same for either one of them. Both founders and investors want to hold as much of the company’s equity in their hands as possible.
How can both interests be met? One way is to set a “CAP”. This represents a “ceiling” on the future valuation of the company, at the time the investment is converted. When a CAP is set, both parties agree that the injected capital won’t represent more than a said amount of equity in the future.
In this way, the investor gets a better price per share than a later investor. If the company ends up raising money at a valuation above the CAP then the investor gets to convert at a share price equivalent to the CAP.
Another term that we can find in these types of documents is the discount. Because the investor might want the investment document to convert to equity at a discount to the later round of financing. Discounts typically range from 10–30%. For illustrative purposes, for example if there is a 50% discount, Instead of buying shares at $1.00, the investor gets to buy shares at $0.50.
Sometimes, these Investment Documents have both a cap and a discount. The Investor will choose the one that gives a better price per share.
Now that we understand the similarities between them, let’s talk about what makes them different.
Other complexities aside, the main characteristic of a CN is that this instrument has an interest that may vary between 2% and 20%. In this sense, the capital will convert into shares of the company together with the corresponding interest. Because the CN is a debt, it is recorded into the company’s book as a passive. ,
With a SAFE or a KISS , there is no interest, so only the capital invested will convert into shares of the company. Also, the company will include the investment in its balance sheet as equity, not as passive (or debt).
Venture Capitalists are patient investors in regards to when their investment will yield results, but they do expect some guarantees.
All instruments state that the investment will be converted into capital when a certain event takes place: the next fundraising round. But the CN and the KISS will also state a certain amount of time that, once passed, will trigger said conversion. This is called “maturity date”. The SAFE, on the other hand, has no maturity date.
When signed, the investor is basically agreeing on the possibility that the startup will never reach the next round, as it is a risky business. As there is no maturity date, as long as the startup doesn’t reach the next round, the investor will not become a shareholder.
Generally, the SAFE and the KISS are more startup friendly vs. CNs, which are preferable for investors. Why? These are simple, easy and fast forms of financing documents for startups, especially for angel and seed fund investors. Therefore, if you have to choose as a startup, go for SAFE or a KISS.
Of course, if you have the choice between 2 term sheets, one involving SAFE or KISS and the other CNs, make a decision based on the specific terms that you are being offered. There are way more terms in these Investment Documents that you have to take into account.
We recommend getting the correct legal advice when deciding which Investment Document to use, since these templates must always be adapted to the startup, the investor, the local legislation and the industry in which you are working.
Let us know what you thought of this content and share it with your entrepreneurial community!