Over the last few decades, three new fundraising instruments have filled the void for early founders looking for easier ways to raise capital: the convertible note, the SAFE and the KISS. This article charts the evolution of these three instruments, what pushed each of them into existence and how they are different (or similar) to one another.
The Pre-Convertible Note Age
When raising capital for a company, there were two routes founders traditionally choose: (1) equity (i.e., selling shares in the company) or (2) debt (i.e., taking out a loan for the company). However, this venture funding landscape felt one-dimensional and not entirely suited for early-stage founders looking to raise capital. Issuing equity via priced rounds, like a Series Seed or Series A, required assigning the company a valuation often before the company had any revenue or customers. In addition, priced rounds required lots of paperwork and were expensive — especially for companies that were pre-product, pre-traction, and pre-product-market fit. Taking out a loan similarly required lots of paperwork and the terms were generally not company-friendly. But companies need capital to grow, so founders were left with two options: raise a priced round or borrow money.
Convertible Notes Enter the Group Chat.
Era I: The Convertible Note
A convertible note is a loan that converts into equity in the company at a specified time — either at its maturity date or when the company raises a priced round, whichever comes first. Like any loan, convertible notes accrue interest in addition to the principal amount of the loan. The principal amount of the loan plus interest is “paid back” to the investor in the form of shares in the company. One benefit of the convertible note is that it does not require the founders to set a valuation for their company and they are often quick and easy to complete.
Convertible notes allowed founders to raise capital in between priced rounds (known as “bridge rounds”).
Convertible Note Terms
A convertible note contains a few key terms:
- Valuation Cap: convertible notes often have a valuation cap, which is the specified maximum price at which the note will convert into equity. Because the valuation cap often ends up being lower than the valuation of the company at the time of conversion, the investors typically receive some equity “upside” if the note converts when the company’s valuation is above the valuation cap. It is possible to invest on an uncapped note, however this is rare as a valuation cap incentivizes investors to participate in a round.
- Interest Rate: convertible notes typically accrue interest at a fixed rate that is equal to or exceeds the Applicable Federal Rate (AFR). As of 2023, the usual range is between 2% - 8%. However, the company won’t pay back the interest in cash, but instead in equity when the note converts.
- Maturity Date: this is the date upon which the convertible note becomes due and payable if it has not already converted into equity.
- Qualified Financing Threshold: this is the minimum amount of money that must be raised by the company in a future equity financing in order for the convertible note to convert into equity. This is normally set at 1x - 2x the principal amount of the convertible notes issued.
- Discount: this is sometimes included with the convertible note and results in the convertible note holders receiving some percent discount on the conversion price of their shares relative to the price that the new money investors purchase their shares.
- Acquisition Premium: sometimes, a startup will be acquired before the convertible note converts into equity. In the event of an acquisition, the acquisition premium grants the convertible note holders the right to get their money back (including accrued interest), plus a premium, which is typically drafted as a multiple of the principal amount of the loan. Note that this provision isn’t always present in convertible notes.
The Challenges of Convertible Notes
Although convertible notes were a step in the right direction for early-stage financings, they weren’t without issues – both practical and philosophical.
Practically, there’s no such thing as a standard convertible note. Founders could set different terms for different investors. And although convertible notes may seem easier to negotiate than priced rounds, they still required founders to negotiate several different terms – from negotiating interest rates and discounts, to maturity dates. Additionally, convertible notes are relatively long (over thirteen pages) and saturated with legalese that can be difficult for founders to grasp without the help of a lawyer.
For Carolynn Levy, there was also a deeper, philosophical issue at play: “convertible notes were debt and venture capital was based on equity. They just didn’t make sense together.”
So, in December 2013, Carolynn Levy set out to create the SAFE.
Era II: The SAFE is Born
A Simple Agreement for Future Equity (SAFE) is an agreement that allows investors to purchase future equity in a company. SAFEs remove two aspects of convertible notes: the maturity date and the interest rate. Removing these two properties mean that SAFEs, unlike convertible notes, are not loans. Instead, SAFEs are invested capital that converts into equity at a specified time, usually at the next funding round or liquidity event.
At only five pages long and with minimal legalese, the SAFE is also much more founder-friendly. “The idea itself wasn’t the innovation,” says Kirsty Nathoo, Y Combinator’s (YC) first employee. “The concept was similar to the convertible note. The innovation was writing such a short document without any of the complex pieces.”
There are four terms that make up Y Combinator’s standard SAFE.
- Valuation Cap: like convertible notes, SAFE notes have a valuation cap that sets the maximum price at which the SAFE converts into equity. The standard YC SAFE is now a Post-Money Valuation Cap Only SAFE.
- Discount: this is expressed as a percentage and results in the SAFE holders receiving a discount on the conversion price of their shares relative to the price paid by the new-money investors. The discount may be in addition to the Valuation Cap in which case the SAFE would convert into shares based on the Valuation Cap or Discount (whichever would result in more shares). YC also has a Discount Only SAFE.
- Most-Favored Nation: an MFN clause allows SAFE investors to amend their SAFE to include any more favorable terms that the company includes in SAFEs issued prior to the conversion of the SAFE. YC has an MFN Only SAFE, but the MFN provision is also sometimes added to SAFEs with a Valuation Cap and/or Discount.
- Pro-rata Rights: allow SAFE investors to maintain their equity stake in future financing rounds by participating in the financing round. Pro rata rights were included in the Pre-Money SAFE, but not included in the Post-Money SAFE so are sometimes granted via an optional side letter to the SAFE.
For Alex Danco, the simplicity of the SAFE was their main selling point: “anyone can use them; and in the early stage Silicon Valley tech community, most people do. You know why? Not necessarily because SAFE notes are a superior deal structure; but they’re easy, they’re expected.”
In 2013, YC introduced the original SAFE as a simpler alternative to convertible notes. This six-page, one-document convertible instrument is known as the “pre-money” SAFE because it calculates the valuation cap on a pre-money basis.
In 2018, YC released an updated version called the “post-money” SAFE. The key difference between the two forms lies in how they handle dilution on the cap table with the Post-Money SAFE making it easier for investors to calculate how much of the company they would own upon conversion of their SAFE. Read more about the differences on our Venturepedia. Today, Y Combinator no longer has Pre-Money SAFEs on its website, making Post-Money SAFEs the standard.
There are four variations of the Post-Money SAFE:
- Valuation Cap Only (this is the most common SAFE type)
- Discount Only
- Valuation Cap and Discount
- MFN Only
The challenges of SAFEs
SAFEs were designed to be founder-friendly and a quick way for companies to raise capital.
But, like any legal document, SAFEs are not immune to issues. As we’ve written before, there are three common pitfalls founders fall into when raising on SAFEs:
- Unanticipated dilution due to raising multiple SAFE rounds with various valuation caps and discounts;
- Accidentally crowding out investors at future priced rounds because there are too many outstanding SAFEs; and
- Mistaking the valuation cap on the SAFE for the company’s actual valuation.
The other downside is conversion – or a lack thereof. SAFEs usually convert into equity at the next financing round, but what happens if a company reaches profitability and decides not to raise another round? In this scenario, while convertible note holders would still be able to ask for their principal amount plus accrued interest, SAFE holders would be left with nothing. Our blog post on Toptal vs. Notion describes this scenario.
While the main issue with the convertible note is its complexity, perhaps the SAFE’s main issue is its simplicity. There is a third instrument, however, that acts as a hybrid between the two: the KISS.
Era III: A KISS to Bridge The Gap
In July 2014, 500Startups announced the birth of the “Keep it Simple Security (“KISS”). When he set out to create the KISS, Greg Raiten – the former General Counsel at 500Startups – had similar motivations to YC’s Carolynn Levy; he wanted to help founders and investors “raise money quickly and easily” and “without getting screwed.” The result was a convertible security that broadened the scope of the SAFE by reintroducing some of the investor protections YC removed from convertible notes.
There are two versions of the KISS:
- Debt KISS: this is closer to a convertible note. It has accruing interest and a maturity date.
- Equity KISS: this is closer to a SAFE and has no interest or maturity date. Instead, the KISS converts into preferred stock once the company raises at least $1MM.
The KISS has the following terms:
- Valuation Cap: KISS also has a valuation cap that sets the maximum price at which the KISS converts into equity.
- Interest Rate (if a debt KISS): a debt KISS accrues interest, typically 5% annually.
- Maturity Date (if a debt KISS): this is the date by which the company must repay the loan, and is typically set at 18 months.
- Qualified Financing Threshold: a KISS automatically converts to preferred stock when the company raises an equity round of at least $1MM. The conversion price is the lesser of the valuation cap or discount.
- Discount: the discount is the amount of reduction in price the KISS holders will receive when their debt converts into equity.
- Major Investor Rights: Major Investors (whose aggregate investment is more than $50K) get basic information rights (e.g. company financials), and participation rights in all future financings. These rights are not often given in either the convertible notes or SAFEs.
- MFN Clause: allows KISS holders to amend their KISS to include any more favorable terms that the company includes in the KISS issued prior to the conversion of the KISS.
- Acquisition Premium: in the event of an acquisition, KISS holders have the option to (a) convert to common stock at the valuation cap or (b) get paid a multiple (usually 2x) on the original investment. Debt KISS note holders can also opt for repayment of their principal plus accrued interest.
The challenges of the KISS
While the KISS reintroduces some of the protections of convertible notes, it also reintroduces some of the problems: since the KISS has more points of negotiation, it has the potential to be more costly and complex than a SAFE to issue. Also, all KISSes in the same round must have identical terms; you can’t stack different KISSes with various valuation caps and discounts like you can the SAFE. This means that “high resolution fundraising” – Paul Graham’s idea that founders should be able to, for example, give better terms to a more helpful investor or one that commits quickly – isn’t possible with the KISS. For these reasons, the KISS never gained traction in the same way the convertible note and subsequently the YC SAFE did. Currently, the YC SAFE is the most common way for founders to raise capital prior to doing a priced round or in between priced rounds.
Early-stage fundraising instruments have evolved to respond to the increase in early founders looking for an easier way to raise capital and the rise of early-stage venture funds looking to fund Pre-Seed and Seed stage companies. The result is three distinct methods of raising capital using convertible instruments. Although each convertible instrument has its pros and cons, the YC SAFE is currently the gold standard in Silicon Valley, at least until something better comes along!