Convertible notes and SAFEs: what you agree to before the round is priced

What are convertible notes and SAFEs, and why do investors like them?

A priced equity round needs a valuation, and at the earliest stage a valuation is mostly guesswork. A convertible instrument lets the investor put money in now and leaves the pricing until a later round, when a lead investor and real numbers can settle it. That is why seed and pre-seed deals so often use one.

The two you will meet are the convertible note (the investor lends the company money, and the loan converts into shares) and the SAFE, or simple agreement for future equity (the investor pays cash for a right to shares later). The SAFE was designed in the United States. According to Founders Factory Africa, it is possibly the most common early-stage instrument in African deals, and much of the continent's early-stage funding between 2015 and 2022 used it.

How does a convertible note work?

A note is a loan with a built-in exit into equity. It usually has four moving parts:

• Interest. It accrues over time and normally converts into shares along with the amount lent, so the investor's stake grows the longer the note stays open.
• A conversion trigger. Usually a “qualifying financing”: a priced round above a stated minimum size. Good agreements also say what happens on a sale of the company or a listing.
• A maturity date. If no qualifying round happens by then, the agreement should say whether the note converts at a default valuation, is extended, or must be repaid. Repayment is the clause that frightens founders, because a young company rarely has the cash.
• A discount, a valuation cap, or both. These set the price at which the note converts. The next section shows what they do.

How is a SAFE different?

A SAFE has no interest and no maturity date, and it is not a loan. The investor pays cash and receives a right to shares when a trigger happens, such as a priced round, a sale or a listing. Until then the investor is not a shareholder and has no right to be repaid. If the company fails first, the SAFE is generally worth nothing, which is why it is a high-risk instrument for the investor and a founder-friendly one.

That founder-friendliness cuts both ways. With no maturity date, a SAFE may never convert if no priced round, sale or listing ever happens. Founders Factory Africa notes that investors have begun to see African SAFEs as too founder-friendly, and proposes a hybrid it calls a “SAFE note” that adds a voluntary conversion right and a liquidation preference. It is worth knowing the term before an investor raises it.

What do a valuation cap and a discount do to your shareholding?

A discount lets the investor convert at a lower price than the new round's investors; 10% to 25% is common. A valuation cap sets a ceiling on the company value used to price the investor's shares. Where an agreement has both, the investor usually gets whichever produces the cheaper price.

Here is an illustration, with assumed numbers and a simplified share count:

• An investor puts in R2,000,000 through a note or SAFE with a R20m valuation cap and a 20% discount. The company has 1,000,000 shares in issue.
• A year later you raise a priced round at a R40m pre-money valuation, so new investors pay R40 a share.
• With no cap or discount, R2,000,000 would buy 50,000 shares (about 4.8% of the company after conversion).
• The discount price is R32 a share, giving 62,500 shares (about 5.9%).
• The cap price is R20 a share (R20m divided by 1,000,000 shares), giving 100,000 shares (about 9.1%).

The investor takes the cap, and ends up with twice the shares they would have bought at the round price. Nothing went wrong; the founder agreed to that when the cap was set. The lesson is to model the cap against the round you expect, not the round you hope for. Real calculations depend on how “fully diluted” is defined and whether the option pool counts, so ask for the formula in writing. Our dilution and cap tables module shows how to run it.

What can go wrong for founders?

• Stacking. Several notes and SAFEs raised over a year, each with its own cap, can add up to a round you never negotiated. Founders Factory Africa observes that repeated convertible raises can effectively become a round of their own. Keep a running table of every instrument and the shares each would convert into.
• A maturity date you cannot meet. A note that falls due before your next round hands the investor leverage. Ask for an automatic extension or conversion at a default valuation instead of repayment.
• A pre-money cap. It hides the investor's final stake until the round happens. A post-money cap shows the minimum percentage the investor will hold, so both sides can see the dilution.
• No conversion, ever. If no priced round arrives, a SAFE can sit on your cap table indefinitely, and an investor may ask for a conversion right or a preference. Decide your position before the conversation.
• The shares you convert into. A note or SAFE often converts into the new round's shares or an equivalent class, so any liquidation preference or anti-dilution term in that round can apply to the early investor too. The Africa Term Sheet Guide compares those clauses across South Africa, the UK, Europe and the US.

What does South African law add?

A convertible instrument is an ordinary contract, but several South African rules decide whether it works in practice. This is a summary of the points we see raised, not legal advice.

• Company law. Your memorandum of incorporation must authorise enough shares of the right class to cover conversion, and the board must resolve to issue them (Companies Act 71 of 2008, sections 36 and 38). Section 40(1)(b) permits issuing shares on conversion rights attached to securities already issued. A special resolution (75%) is required where the instrument goes to a director, future director, prescribed officer or related person, or where the shares issued on conversion reach 30% or more of the voting power of the class (section 41). Statutory pre-emption rights do not apply to shares issued on conversion rights (section 39), but your shareholders' agreement may still give existing holders consent or pre-emption rights, so check it and obtain written waivers where needed.
• Tax. A loan that can convert into shares may be a “hybrid debt instrument” under section 8F of the Income Tax Act. If it is, the interest is treated as a dividend: the company loses the deduction and dividends tax applies. As the rules were introduced in 2014, conversion at a price where the market value of the shares equals the amount owed was excluded. The rules have been amended since, so have a tax practitioner review any note, particularly one with interest or a connected-person lender.
• Exchange control. Shares held by a non-resident in a South African company are controlled securities and must be endorsed “non-resident” by an authorised dealer, usually your bank; dividends cannot be paid to a foreign holder until that is done. If the investor is abroad, involve your bank early and ask your attorney how a foreign-funded note or SAFE is classified, because we have not covered foreign loans here.
• Consumer credit. The National Credit Act generally does not apply to a company borrower with assets or turnover of R1,000,000 or more. A very small borrower dealing at arm's length could be caught, so check each note.

Which should you use: a note, a SAFE or a priced round?

Use a SAFE when you want speed, the investor is comfortable with no repayment rights, and you expect to price a round within about a year. Use a note when the investor wants interest and a maturity date, or when you would rather bargain over a repayment date than over a preference. Move to a priced round when the amount is large enough that the lawyers' cost is small next to the dilution at stake, or when several convertibles are already open and you need to see where you stand. If you are raising, our venture capital deal structures guide and the investor readiness checklist are good next reads.

Before you sign, ask yourself:

• Is the cap pre-money or post-money, and what is the formula for fully diluted shares?
• What is the smallest round that triggers conversion?
• What happens at maturity: repay, extend or convert?
• Which class of shares does it convert into, and with what rights?
• Does the investor get a most-favoured-nation clause, pro-rata rights or information rights?
• Are your authorised shares, shareholder consents and tax position in order?

Sources. MJ Kotze Inc, Convertible loan agreement (Companies Act sections 36 to 41, discount and cap ranges, National Credit Act note); Founders Factory Africa, The evolution of SAFEs in Africa: from CLNs to SAFE 2.0; The Sovereign Group, SAFEs: a new investment option for African start-ups (October 2022); Cox Yeats, Hybrid debt instruments and ENS, Convertible debt instruments (April 2014; sections 8F as introduced, since amended); Cliffe Dekker Hofmeyr, Foreign direct investment into South Africa: some exchange control considerations (13 May 2021). The worked example is illustrative and uses assumed figures.