Should your startup use a convertible note, SAFE, or preferred stock?
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The basic trade off you're making when you raise money as a founder is you're giving someone ownership in your company via a lot of expensive legal paperwork and you're getting cash in the door, right? And so, picking the security that you're giving the investors, whether that's the preferred stock, the SAFE note, the convertible debt, is actually important. You want to be thoughtful about this and make a good decision. So I've done videos explaining what convertible debt is, what SAFE notes are, what preferred equity is or are, so check those videos out. But I'm going to give you the CliffNotes reasons why certain parties actually like different types of securities. So for preferred equity, that is a favorite of venture capitalists.
And so, the price per share in preferred equity is defined. You know you're paying a dollar a share, and when you add up all the shares in the company, you times that by a dollar and that's the valuation of the company, right? Very, very clear. There's no conversion feature to be had later, which is the case with SAFE notes and convertible notes, which I'll talk about in a second. It's plain as day what you're paying and what the valuation of the company is at the time of the deal. It also starts the QSBS clock immediately. QSBS is frankly a tax shelter or a way of mitigating your capital gains taxes down the line if the startup qualifies. And I think there's like kind of five main qualifications. I've done that in another video, you can check that out, but QSBS can save up to $10 million, or I think it's 15X; don't quote me on that, of whatever the investors' base is, shelter that from capital gains taxes.
But guess what? The IRS hasn't clarified whether that actually works or not. So we're all going to find out in a couple of years, because SAFE notes have been popular for awhile, whether the IRS actually recognizes that as the date of the clock starting. So that'll be a fun little surprise and I'll definitely do videos on that whenever they come out with a ruling. But next up, the reason why investors like preferred stock is there's a liquidation preference, typically 1X, but very clearly defined. And that means that they get their money back, their invested capital back, before the common stock starts to participate.
Now, preferred equity can always be converted into common later on. And that's what happens when a company does an IPO. The night before the IPO when it starts trading on the NASDAQ or New York Stock Exchange, all the investors typically will convert over, assuming it makes sense economically for them.
The only big material difference is that convertible debt is redeemable, typically kind of like every 20, 24 months, sometimes even 36 months. SAFE notes are not really typically redeemable.
And that works for the founders because they got the capital they needed at the time where they probably didn't have a lot to show for it. So the cap is kind of a proxy for valuation. This is all finalized later when another round, typically a preferred round comes in and there's a clear valuation. The cap is probably the most important term in a SAFE note and convertible debt. Again, SAFE notes and convertible debt, much, much, faster and cheaper to negotiate. They're usually like a two or three page document. A preferred document can be significantly longer, 20, 30 pages, something like that.
This happens quite a bit. The round might start at a $10 million cap. Some other investors put their money at 15, and then someone late puts money at 25. It's hard to keep all those dilution events in sync in your head, and it's also kind of hard to frankly model it out. There are tools like cap table management software that can help you model it. But even those are a little tricky when there's multiple notes or SAFE notes, convertible debt interacting with each other because it's kind of like a circular calculation. If anyone's ever done a lot of Excel, circular calculations can be a little maddening. So SAFE notes, convertible debt are not perfect.
There's some downsides with them too. Generally, I recommend early stage companies do the SAFE or converts because they're cheap, they're fast and easy. You can kind of get them done quickly. But if you're raising a material amount of money, like a lot of money, I would always go for a preferred round. It's just easier to get it documented correctly.