After reaching a peak in 2021, the venture capital market for tech companies has slowed in 2022, evidenced by a reduction in global venture funding, lower valuations and more aggressive negotiations on deal terms.
Whilst some founders with sufficient runway may opt to play the waiting game and wait until the market picks up again, there are other options available.
In particular, we have seen an increase in the use of convertible loan notes and simple agreements for future equity (“SAFEs”) (also known as Advance Subscription Agreements in the UK). We look at the advantages of these financing models as well as highlight key issues to be aware of with both.
Convertible loan notes
What is a convertible loan note?
Convertible loan notes are a hybrid form of debt finance. They offer a company a repayable loan (either on a secured or unsecured basis) that is convertible into an equity investment upon the occurrence of certain defined events.
Convertible loans notes are typically structured so as to convert into equity at some point in the future, commonly at a discounted price. The most common trigger for conversion is the occurrence of a subsequent equity investment that exceeds an agreed financial threshold (usually referred to as a Qualified Financing).
Convertible loan notes typically carry a maturity date. If the convertible loan notes have not been converted into equity by the maturity date, the convertible loan note will usually contain a provision which provides for redemption of the loan notes.
What are the key advantages of using a convertible loan note?
Convertible loan notes are a convenient method of raising capital, especially for start-ups, because no valuation is required to issue them. They allow issuers to defer valuation negotiations to a later stage, typically the occurrence of a subsequent Qualified Financing. At that later point, it may be perceived that the market will be more settled making it easier to agree a valuation, the company itself may be further down its growth trajectory and thus command a higher valuation or it may simply be that the parties are more willing/able to enter into a protracted discussion as to price and deal terms.
One of the other main benefits of a convertible loan note is their relatively simple structure which means that financing via convertible loan notes tends to be faster and involve lower legal fees than a conventional priced round. In addition, because of their convertible nature, borrowers who issue convertible debt will generally pay a lower rate of interest, if any, on the debt than they would under a conventional loan, thus reducing their costs of borrowing.
A further advantage of financing via convertible loan notes is that they allow the company to retain control over its operations until the conversion date as the noteholders are not shareholders in the company.
What are the key disadvantages of using a convertible loan note?
Firstly, as with any equity issuance, conversion of a loan note will see a company’s existing shareholders diluted. This may result in control shifting away from the original founders of the company and towards the holders of the convertible loan notes.
Secondly, as convertible loan notes are a type of debt, they can impact a company’s ability to finance its operations during times of economic stress. A company that finances with convertible debt during good times to the point where its debt/assets ratio is at the upper limits for its industry, simply may not be able to get financing at all during times of stress.
SAFE
What is a SAFE?
A SAFE is an agreement between an investor and a company that provides rights to the investor for future equity in the company similar to a warrant, except without determining a specific price per share (or a valuation) at the time of the initial investment. Much like a convertible loan note, this allows the company to defer the official valuation to a later time, but unlike a convertible loan note, it is not a debt instrument.
A SAFE is useful tool for start-ups trying to attract investors during early fundraising rounds and is generally considered to be a more founder-friendly alternative to a convertible loan note.
What are the key advantages of using a SAFE?
One of the main advantages to a start-up of issuing a SAFE is that they are able to raise funds quickly and without a valuation. Although there are certain key terms which need to be negotiated, for example, a valuation cap and how a qualifying funding round will be defined, generally these negotiations are likely to be less protracted than formal equity funding rounds. They are also appealing to investors as they allow for protections to be built in such as a valuation cap and / or a discount.
In addition, as the company does not need a valuation in order to issue a SAFE, it somewhat safeguards the company from giving away too much equity at a low value early on in the company’s lifecycle. Due care and attention does however need to be paid when setting a valuation cap to protect the founders from being substantially diluted.
There is no expiration date for a SAFE. With a SAFE, instead of paying an investor back in cash at a maturity date, the investment automatically converts into shares at a pre-agreed valuation at a certain date. The number of shares that the investor will get for their investment depends on the key terms agreed between the parties.
What are the key disadvantages of using a SAFE?
SAFEs do not come without risks and need to be managed well to ensure there is not an issue with significant dilution further down the line.
From the founders’ perspective, because shares are being given away at a discount, their own shares will be further diluted when the shares are issued in accordance with the terms of the SAFE.
Additionally, the use of a SAFE may deter other future investors in later funding round as the holders of the SAFEs will obtain their shares at a discounted price and therefore will receive a higher percentage of the equity relevant to the amount of funds advanced in comparison to new investors.
As ever, there are various pros and cons with each method which should be considered carefully. The Corporate team at Fox Williams has extensive in-depth experience of the technology sector and can add significant value to companies dealing with the issues arising when fundraising in the current market.
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