What transactions force automatic conversion of convertible notes or SAFEs?
Takeaway: Convertible notes and SAFEs are usually automatically converted in equity financings in which a certain amount of money is raised. The specific amount is set forth in the notes and is usually between $3-5mm.
Convertible promissory notes and Simple Agreements for Future Equity (SAFEs) have become increasingly popular financing instruments for early-stage startups. While these instruments provide flexibility and simplicity for founders and investors, it's important to understand the circumstances that can lead to an automatic conversion into preferred stock. In this post, we will explore the types of financings that can trigger such conversion and what it means for both parties involved.
Convertible Promissory Notes and SAFEs: A Brief Overview
Before diving into the specifics, let's briefly discuss the differences between convertible promissory notes and SAFEs. Both convertible promissory notes and SAFEs are instruments that convert into equity during a future financing round, typically with a discount or cap on the conversion price. Convertible promissory notes, however, are technically debt, meaning they accrue interest and the startup could have to pay them back if they aren’t converted by the maturity date.
Qualifying Financing Events: The Key to Automatic Conversion
A qualifying financing event (QFE) is a significant financial milestone that triggers the automatic conversion of convertible promissory notes or SAFEs into preferred stock. QFEs usually involve raising a certain amount of capital through the issuance of preferred stock. The terms and conditions of each instrument specify the criteria for what constitutes a QFE.
Types of Financings that Trigger Automatic Conversion
The most common types of financings that trigger automatic conversion include:
Equity Financing Rounds: The convertible promissory notes or SAFEs typically convert during a priced equity financing round, such as Series A, B, or C. These rounds involve the issuance of preferred stock to investors, with the convertible instruments converting into the same class of preferred stock as the new investors (or a shadow series with substantially the same rights).
Change of Control: A change of control, such as a merger or acquisition, can also trigger an automatic conversion. In such cases, the convertible instruments would convert into preferred stock just before the change of control, ensuring that the noteholders and SAFE holders participate in the transaction on an equal footing with other preferred stockholders.
Conversion Mechanics and Valuation
When a QFE occurs, the convertible promissory notes or SAFEs automatically convert into preferred stock based on the terms previously agreed upon by both parties. This typically involves:
Conversion Price: The conversion price is the price per share at which the convertible instruments convert into preferred stock. It is typically determined by applying a discount rate or a valuation cap to the pre-money valuation.
Conversion Shares: The number of conversion shares issued is calculated by dividing the outstanding principal and accrued interest (in the case of convertible notes) or the purchase amount (in the case of SAFEs) by the conversion price. This determines the number of preferred shares issued to the noteholders and SAFE holders upon conversion.
Conclusion
Understanding the automatic conversion of convertible promissory notes and SAFEs into preferred stock is essential for both founders and investors. It helps them navigate the complex world of startup financing and make informed decisions when entering into financing agreements. By recognizing the types of financings that trigger conversion and the mechanics involved, all parties can better anticipate the outcomes of their investment choices and ensure a smoother financial journey for the startup.