Service page: Commercial contracts lawyer: drafting, review and enforcement.
What is the difference between a convertible note and a SAFE?
A convertible note is a fundraising instrument in which an investor pays money to a startup and receives a promissory note that can be converted into shares in the future (usually in the next equity round). A SAFE (Simple Agreement for Future Equity) is a similar but simpler tool: it is not debt, but a simple agreement to issue shares in the future.
The main difference: a convertible note is essentially debt: it has interest and a maturity date on which the debt must be repaid or converted into shares. A SAFE, by contrast, is a simple undertaking with no interest and no maturity date, and the investor is not a creditor of the company. This means that with a SAFE you wait until there is a priced round or another significant event.
Why do startups prefer convertible notes?
Convertible notes are a popular tool for startups raising early capital (a seed round). They allow a startup to raise capital quickly with relatively low legal costs, while the investor gets the chance to share in future growth.
- Faster to negotiate than a full equity deal (a priced round): usually a few weeks instead of months
- Low legal costs, mainly because no valuation is needed at this stage
- Conversion on better terms for the startup if it grows strongly (the cap is the interesting mechanism here)
- The investor takes a high risk at an early stage, and in return gets a discount on the share price in the next round
At the same time, convertible notes also create legal and financial risks that need to be well understood.
These are the terms that decide everything in a convertible note
These are the critical terms in a convertible note that set the terms of conversion into shares:
- Valuation Cap: the ceiling on the note’s value, the maximum valuation at which conversion will take place. For example, a startup with a cap of $5 million: if the next equity round is at a valuation of $10 million, the investor benefits from the lower value.
- Discount Rate: a discount on the conversion price, at a rate set in negotiations (for example, 20%). This is why early investors get a discount on the future price.
- Interest Rate: the note’s interest: annual interest of a few percent, as agreed
- Maturity Date: the expiry date, usually 2–3 years. If there is no funding round, the debt goes back to the investor or there is a forced conversion.
- MFN Clause (Most Favored Nation): an important clause: if another investor gets better terms (a higher discount or a lower cap), the holder of the clause is entitled, depending on its wording, to adopt the same terms.
A badly drafted convertible note can lead to serious disputes at conversion or in the next equity round.
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SAFE: what exactly is it, and where is the risk?
A SAFE is a document developed by the accelerator Y Combinator in the United States, where it is very widespread, but it is less common in Israel. It is a simple agreement in which an investor pays money to a startup in return for an agreement to issue shares in the future, when there is a financing round or another significant event (such as an exit). A SAFE creates no debt and no interest. The difference between the two documents lies only in the wording, so it is checked with a commercial contracts lawyer before signing, not in the next round.
Advantages of a SAFE: great simplicity, very low legal costs, and no debt on the startup. There is no annual interest and no maturity date. However, an investor in a SAFE does not have the rights of a shareholder until a conversion takes place.
In Israel, the legal status of a SAFE under the Companies Law, 5759-1999 (חוק החברות, התשנ״ט-1999), and the securities laws is still developing. It is advisable to consult a lawyer who works in company law before adopting the SAFE model.
What can go wrong? The risks you should know
Investors in convertible notes and SAFEs need to understand the risks. If the startup collapses or closes before a funding round, the investor can lose all their money.
- The risk of losing the whole investment if the startup collapses before a funding round
- In a convertible note: the investor is a creditor, so in a liquidation it ranks ahead of the shareholders
- In a SAFE: the investor has neither the status of a creditor nor the status of a shareholder until conversion: its only protection is the wording of the agreement
- Uncertainty about the final conversion price because of market fluctuations or disagreements
- A risk of litigation if the wording of the note is unclear or not standard
Investors and founders should get legal advice before signing convertible notes or a SAFE.
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Convertible notes in Israel: what is different in practice?
In Israel, convertible notes are a popular tool for raising startup capital at early stages. However, the SAFE is less common in Israel, and it has no dedicated arrangement in law: it is a contract, whose validity is examined under contract law, and the open questions concern mainly drafting, taxation and securities law.
In securities law, the practical question is to whom the offer is made. If the instrument is a “security” as defined in section 1 of the Securities Law, 5728-1968 (חוק ניירות ערך, התשכ״ח-1968), offering it to the public requires a prospectus (section 15). However, an offer to investors whose number, together with those who bought from the offeror in the 12 months before it, does not exceed 35 is not considered an offer to the public (section 15A(a)(1) of the Law and regulation 2 of the Securities Regulations (Details for Sections 15A to 15C of the Law), 5760-2000 (תקנות ניירות ערך (פרטים לענין סעיפים 15א עד 15ג לחוק), התש״ס-2000)). Investors of the types listed in the First Schedule to the Law are not counted (section 15A(b)(1)), and buyers of shares and of securities convertible into shares are counted separately from buyers of other securities.
The Companies Law, 5759-1999, does not give clear provisions on SAFEs, while convertible notes are treated under the ordinary rules on debt. For tax purposes, a convertible note is usually treated as debt until conversion, and the conversion itself may have tax consequences: these should be examined in advance with a tax advisor.
Most investors in Israel will still prefer convertible notes or full priced rounds, to avoid legal novelty. Startups looking for international investors or for VC firms abroad may be asked to use a SAFE, but should be aware of the legal issues.
When is it important to get help from a lawyer?
Startups and investors need legal advice before signing convertible notes or a SAFE. A lawyer who works in this field can make sure that:
- The terms are fair and balanced between the startup and the investor
- The wording is clear and without ambiguity
- The terms comply with Israeli law and with securities law
- Better terms are negotiated (a lower cap, a higher discount)
- There is protection against MFN clauses and other important clauses
Legal advice already at this stage can reduce legal risks later on.
Checklist
- Practical tip: when advising a startup on a convertible note, check the cap against the discount in different scenarios. Sometimes the cap is more favorable to the investor if the company is expected to grow quickly. In the analysis, always present two scenarios: a next round at a high valuation (the cap decides) and a next round at a low valuation (the discount decides).
- Relevant legal issue: Israeli law has no dedicated arrangement for convertible notes, and the legal analysis relies on general principles of contract law and company law. That is why it is important to draft the note very carefully, and not to assume that there is a binding precedent that fills the gaps in the drafting.
- Common mistake: founders sometimes sign a convertible note without understanding that it is full debt: if there is no future equity round, the note goes back to the investor as debt. It is important to give the client a clear plan for future financing.
- Tactical point: the MFN (Most Favored Nation) clause is one of the most important clauses. If the first investor signed a note with a 20% discount, and in the following months a second investor signed with a 25% discount, the first investor is entitled, depending on the wording of the clause, to adopt the 25%. In this way the best terms given to any investor roll over to all the early investors: plan for this in advance.