Convertible notes and SAFEs often make sense for startups because they don’t require anyone to know the value of the company. Instead, the company and early investors can piggyback on a later investment when the value of the company might be easier to determine and the size of the investment justifies figuring it out.
Which raises the question, when should the convertible note or SAFE convert?
In the Silicon Valley ecosystem that’s an easy question. Per the Y Combinator forms, a convertible note or SAFE converts at the next sale of preferred stock, which necessarily involves a valuation of the company.
That works in the Silicon Valley ecosystem because (i) in the Silicon Valley ecosystem investors always get preferred stock, and (ii) the Silicon Valley ecosystem is largely an old boy network where founders and investors know and trust one another.
As I’ve said before, the Crowdfunding ecosystem is different. There are at least two reasons why the Y Combinator form doesn’t work here:
- For a company that raises money with a SAFE in a Rule 506(c) or Reg CF offering, the next step might be selling common stock (not preferred stock) in a Regulation A offering. The SAFE has to convert.
- Say I’ve raised $250K in a SAFE and think my company is worth $5M. If I’m clever, or from Houston*, I might arrange to sell $10,000 of stock to a friend at a $10M valuation, causing the SAFEs to convert at half their actual value. All my investors are strangers so I don’t care.
Which brings us back to the original question, what’s the right trigger for conversion?
Half the answer is that it should convert whether the company sells common stock or preferred stock.
Now suppose that I’ve raised $250K in a SAFE round. The conversion shouldn’t happen when I raise $10,000 because that doesn’t achieve what we’re trying to achieve, a round big enough that we can rely on the value negotiated between the investors and the founder. What about $100,000? What about $1M?
In my opinion, the conversion shouldn’t be triggered by a dollar amount, which could vary from company to company. Instead, it should be triggered based on the amount of stock sold relative to the amount outstanding. So, for example:
“Next Equity Financing” means the next sale (or series of related sales) by the Company of its Equity Securities following the date of issuance of this SAFE where (i) the Equity Securities are sold for a fixed price (although the price might vary from purchaser to purchaser), and (ii) the aggregate Equity Securities issued represent at least ten percent (10%) of the Company’s total Equity Securities based on the Fully Diluted Capitalization at the time of issuance.
You might think 10% is too high or too low, but something in that vicinity.
Finally, the conversion should be automatic. Republic sells a SAFE where the company decides whether to convert, no matter how much money is raised. In my opinion that’s awful, one of the things like artificially low minimums that makes the Reg CF ecosystem look bad. You buy a SAFE and the company raises $5M in a priced round. The company becomes profitable and starts paying dividends. You get nothing. You lie awake staring at your SAFE in the moonlight.
Questions? Let me know.