Convertible notes regaining popularity

There is a growing frequency of convertible notes among startup financings structured as convertible instruments. The graph below looks at deals that are either SAFEs (Simple Agreements for Future Equity) or convertible notes and charts the prevalence of each. While SAFEs remain more frequent, convertible notes have regained some popularity over the last few quarters, after declines in prevalence starting in 2020. In Q1, 31.9% of convertible instruments were convertible notes. This is a slight increase from the 30.6% seen in Q4 2023, and significantly higher than the 23-24% from the first three quarters of last year.

For background, convertible instruments are financial contracts that allow investors to provide capital that converts into equity when certain conditions are met, such as a future financing round. Convertible notes are a type of convertible instrument that carries an interest rate and maturity date, and which typically converts into preferred equity in a future round. Convertible notes are debt instruments.

SAFEs are not debt instruments, but are instead contracts that don’t carry interest, but offer the promise of future equity upon a trigger event. Both convertible notes and SAFEs typically come with a valuation cap and/or discount, mechanisms that advantage the investor when an instrument converts.

A preference for convertible notes over SAFEs could indicate that investors are seeking more structure and security. Convertible notes provide investors with a right to repayment if the company doesn’t raise another round of financing. SAFEs can be considered riskier for investors since there is no obligation for the company to repay the investment if certain conditions are not met. SAFEs are sometimes preferred because they are simpler to implement, but the growing use of convertible notes could point to a market where investors are willing to engage in more detailed and complex negotiations to ensure their interests are protected.

Meanwhile, interest rates on convertible notes have steadily risen over the last year. The chart below looks at interest rates on convertible notes with valuation caps. We see that the average interest rate stood at 8% in Q1 compared to 6% one year prior. The data indicates that early-stage investors who funded startups through convertible notes are being compensated more in the form of interest, though this is also a result of the current macro environment which sees the Fed holding rates steady at a 23-year high.

At the same time, the frequency of uncapped SAFEs have fluctuated. Uncapped SAFEs accounted for 9% of all SAFEs in Q1, declining from a four-year high of 16% in Q3 of 2023. Uncapped SAFEs are generally considered founder-friendly as there is no maximum valuation at which the instrument will convert. Usage of uncapped SAFEs may speak to investor confidence in future valuations and higher investor risk tolerance. The decline over the first quarter of 2024 could point to a reversion towards levels of investor caution that have been more commonly seen over the last few years, after a brief spike in investor risk appetite in the third quarter of last year. However, we will want to see a few more quarters of data before identifying a trend.

Aumni will continue to monitor these, and other, market developments.

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