SAFE vs convertible note in Australia

A priced round sets a valuation and issues shares at a price. Very early on, nobody wants to argue about a valuation that the next round will set anyway, and the company usually needs the money faster than a full share subscription takes. A convertible instrument puts the argument off. The investor pays now, and the number of shares they get is worked out later from the price the next round sets, with a reward built in for having come in early.

Convertible notes are the older instrument, borrowed from debt markets. The SAFE (simple agreement for future equity) was published by Y Combinator in 2013 as a note with the loan features taken out, and Australian versions of it are now common in pre-seed and seed rounds.

A note is a debt the company owes. The investor lends a sum, interest accrues at a stated rate (usually added to the balance rather than paid in cash), and the note has a maturity date. The note spells out what happens at each event:

• A qualifying financing, usually a priced round raising at least a stated amount, converts the principal and any accrued interest into the shares issued in that round, at the conversion price.
• Maturity with no round: the company repays the note, or it converts at a fallback price, or everyone agrees to extend. Which of those applies is the clause to read most carefully, because a repayment right can arrive before the company can afford it.
• A sale of the company before conversion: repayment, often at a multiple, or conversion just before the sale.
• Insolvency: the note holder is a creditor, so they rank ahead of shareholders, and ahead of or level with other creditors depending on whether the note is secured.

A SAFE is a contract, not a loan. The investor pays the purchase amount and gets a right to shares on a future event. There is no interest, no maturity date and no right to be repaid, so the company carries no debt and no deadline. The events are:

• An equity financing, which converts the purchase amount into shares of that round's class at the conversion price. The original SAFE converted on any priced round; many Australian forms add a minimum round size.
• A liquidity event, meaning a sale of the company or a listing, where the holder takes whichever is greater: their money back or the shares it would have converted into.
• A dissolution, where the holder gets the purchase amount back ahead of shareholders, out of whatever is left.

The valuation cap and the discount are what make either instrument worth signing early. The cap is the highest valuation the money will convert at, whatever the round says the company is worth. The discount is a percentage off the round's price per share. An instrument can carry one or both, and where it carries both the investor converts at whichever price gives them more shares, which is the lower one.

Say an investor puts $100,000 into a note with a $5 million cap and a 20 per cent discount. The next round values the company at $8 million before the new money, which on 10 million fully diluted shares is $0.80 a share. The cap price is $5 million divided by those 10 million shares: $0.50. The discount price is 80 per cent of $0.80: $0.64. The lower price wins, so the investor converts at $0.50 and gets 200,000 shares. A round investor paying $0.80 for the same $100,000 gets 125,000.

Two details change the answer. A pre-money cap divides by the shares on issue before the round, with the convertibles' own shares left out, so several instruments converting together dilute each other. A post-money cap fixes each holder's percentage instead. And a qualifying financing threshold means a small round does not trigger conversion at all. Both details are in the document, and the document governs.

For the fundraising part of the Corporations Act, a security includes a share, a debenture, a right or interest in either, and an option to be issued one (s92(5), applied by s700). A convertible note is a debenture: a promise by the company to repay money lent to it as a debt (s9). The exception for lenders who lend as a business does not cover an angel or a fund. A SAFE has no promise to repay, so it is not a debenture, but a contractual right to be issued shares fits the definition as a right in a share or an option to be issued one. ASIC has published no view on SAFEs. Australian lawyers treat them as securities and issue them under s708 exemptions, and so does Struck.

So the same rules apply as for shares. An offer of either instrument needs a disclosure document unless an s708 exemption applies, and a private company cannot offer either to the public. For the small-scale count, the investor takes one of the 20 places when the instrument is issued, and the purchase amount counts toward the $2 million on that day, together with anything that becomes payable on conversion (s708(7)). When the instrument later converts, the shares go to the same investors. Which exemption that share issue relies on is a question for the company's lawyer; the money is not counted twice.

Note holders and SAFE holders are not shareholders until conversion. They have no votes, they are not on the register of members, and they do not count toward the 50 non-employee shareholders a private company may have (s113(1)). That is one reason a company expecting many small investors sometimes prefers a convertible instrument to a priced round it is not ready for, though each of them still uses an s708 place at issue and joins the register at conversion.

The early stage investor tax incentives are worth knowing about before you choose. An investor in new shares of an early stage innovation company can claim a tax offset of 20 per cent of what the company received for the shares, capped at $200,000 a year including amounts carried forward, and can disregard the capital gain on those shares if held for at least one year and less than ten. An investor who is not sophisticated is limited to $50,000 of such investments a year, and loses the incentives for the whole year if they go over.

A note or a SAFE is not a share. The ATO says that where shares are issued by converting convertible notes, it is the date of the conversion that matters: the company has to be an ESIC immediately after the conversion shares are issued, and the offset falls in that income year. The ATO has written about the timing and not about how the amount is measured for a converted note, and it has not written about SAFEs at all. The same reasoning is applied to SAFEs in practice, and your adviser should confirm it for your case.

The two instruments also differ in ordinary tax. Interest on a note is income to the investor and, in the usual case, deductible to the company. A SAFE has no interest. Whether converting triggers a capital gains tax event, and what the resulting shares cost for tax purposes, depends on the document, so ask an accountant before signing rather than after.

A note suits an investor who wants a lender's protections: a maturity date that forces a decision, interest for the wait, and priority if things go wrong. It suits a company that is confident a priced round is coming inside the term. The risk is the maturity date. It can arrive before the round does and hand the investor a repayment right the company cannot meet.

A SAFE suits a company that wants money in quickly, with one short document and no debt on the balance sheet, and investors who accept a contractual right with no maturity and no interest. Here the risk sits with the investor. With no cap, the only reward for coming in early is the discount, and with no priced round, the SAFE just waits.

Whichever you pick, three numbers decide what the investor ends up with: the cap, the discount and the qualifying financing threshold. Read them together with the next round in mind.

A raise on Struck is a priced round, a SAFE, a convertible note, convertible debt or options. A capped raise carries its cap and discount on the term sheet instead of a price per share, its investors are qualified under s708 like any others, and at completion each investor's instrument is recorded as an instrument, not as shares. When a later priced round on Struck locks its terms, the outstanding instruments are converted into the register at the lowest of the cap price, the discounted round price and the round price itself, previewed before the close and issued with it. Maturity, interest and most-favoured-nation clauses are not automated. The signed instrument governs, and the conversion is a tool for carrying it out. See instruments and terms.