Raising money for a start-up can take many different forms. One way is to use convertible instruments such as convertible notes, SAFEs and KISSs. When using a convertible, the start-up receives the investment but does not issue shares at that stage. The agreement can ‘convert’ into shares in the future, hence the name. Conversion happens upon the occurrence of a specific event, such as an equity funding round or an IPO.
There are many benefits to using convertibles.
• It allows the start-up to access capital quickly without having to issue shares.
• The start-up valuation can be either a pre-money or a post-money valuation.
• It is usually quicker and less expensive than traditional equity funding rounds.
• It is a more straightforward process with fewer terms and conditions.
Whilst the benefits of convertibles are obvious, the more difficult question is which type of convertible to use. Overall, the choice between these instruments depends on the specific needs and goals of the start-up and the investor.
Common types of convertibles
SAFE
A SAFE (which stands for Simple Agreement for Future Equity) is the most popular type of convertible for early-stage startups. It was originally created by Y Combinator in 2013. It is an investment instrument that provides funding to start-ups or companies in exchange for future equity. A typical SAFE sets out the investment amount, a valuation cap, and/or a discount, but the exact content depends on the type of SAFE. It does not have a maturity date, and it does not charge interest.
No maturity date means that if an equity funding round never happens, the investment does not have to be repaid.
SAFEs are simpler and faster to issue and do not have many of the complex terms found in traditional start-up or venture capital investments. Typically, investors won’t have additional investor rights unless agreed to in a side letter.
Although convertible notes were favoured at some stage, SAFEs have become the most common and popular convertible for start-up funding today.
KISS
KISS in funding stands for “Keep It Simple Security”. It is a type of convertible created by 500 Global. Some consider KISS as a hybrid between SAFEs and convertible notes. Similar to SAFEs, KISS is used by start-ups to raise capital from investors. It has many of the same elements as a SAFE.
KISS is a simplified version of a convertible note designed to make raising capital easier and more streamlined for both companies and investors. It is a cost-effective solution for early-stage start-ups to access capital.
Usually, KISS carries MFN (“most favoured nation”) rights, which gives the investor the right to upgrade their rights under the convertible to any more favourable rights granted to future investors.
KISS can include maturity dates (by default, 18 months) and carry a stated interest. KISS converts automatically to preferred stock when a priced equity round occurs, but only if the equity round is above a specified amount, for example, $1M. If the company is sold before conversion, the investor can typically opt to receive twice its investment (this multiple can vary) or convert at the valuation cap.
Convertible notes
Convertible notes are structured more like quasi-debt, with interest accruing until conversion or maturity. Typically, the investor loans the money to the start-up; instead of repaying the loan with interest, the investor will receive equity in the company.
The interest is usually added to the investment when the loan is converted to shares. Typically, convertible notes have maturity dates – a date by which the loan must be converted or repaid. Alternatively, repayment can be replaced by mandatory conversion, which can be tricky – e.g. how do you set the terms, if it’s the first equity round, what documents do you use etc.).
Although it provides a flexible alternative to traditional equity funding, interest and fixed maturity dates are not ideal for early-stage start-ups.
What are the differences between the convertibles?
SAFEs, convertible notes, and KISS are all investment instruments start-ups and early-stage companies use to raise capital. All are intended to be converted to equity.
The main differences between these instruments are as follows:
- Complexity
SAFEs are typically the simplest convertible to use.
Convertible notes are more complex due to being loans with interest and maturity dates.
KISS has many of the same elements as SAFEs but could include maturity dates, interest, and other investor rights.
- Interest and maturity
SAFEs are not loans. There is no interest and no maturity date.
Convertible notes accrue interest until conversion. The maturity date for convertible notes is usually 18-24 months; ideally, the next funding round will happen before the maturity date. Paying back the loan is generally not ideal for a start-up nor is a forced conversion without an equity round. In this respect, SAFEs are preferable to convertible notes for the founder.
KISS can accrue interest at a defined rate and may have a maturity date, depending on the type of KISS.
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Which one should you choose?
There is no simple answer. It will depend on your specific circ*mstances.
Convertible notes give you quick access to capital, but you risk having to pay back the loan if it reaches the maturity date before the next funding round. Convertible notes provide more investor protection but are generally quite complicated. That is why stakeholders prefer SAFEs or KISS these days.
SAFEs, in comparison to convertible notes, are not debt. There is no maturity date and no interest. If the equity funding round never happens, the investment does not have to be refunded. SAFEs are simple and don’t need complicated negotiations, making them very founder friendly. Typically, you would, but you don’t have to include a valuation cap and a discount price on conversion. However, SAFEs lead to preferred shares.
KISS generally have many of the same elements as SAFEs but with some additional investor protection.
At the beginning of any start-up, you need to find that balance between the founder needing capital to grow the business and investors who typically want a share of the equity for their investment. This can be difficult when the company has no valuation yet. That is why convertibles were invented.
Each convertible instrument has positives and negatives for founders and investors. The trick is to find the one that suits both the founder and the investor in the circ*mstances.
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