Convertible loans vs. SAFEs in Estonia: Which is safer for Early-Stage Startups?

Mirko Kikkamägi, Senior Associate at TGS Baltic and Tenity Community Partner, discusses the comparative safety of convertible loans versus SAFE agreements for early-stage startups in Estonia in this, his latest article.

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In Estonia, early-stage startups looking for funding options might find equity investments overly complex and costly due to legal expenses. To simplify the funding process, many choose between two popular instruments: convertible loans and SAFEs (Simple Agreement for Future Equity)[1].Each method involves an initial cash investment by the investor, who in return, is promised shares at a later date. The choice between these instruments depends on various legal and practical considerations.

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Convertible loans

A convertible loan is essentially a debt that may carry interest and converts into equity under predetermined conditions—either at the loan’s maturity or during an equity financing round.While theoretically repayable, convertible loans are seldom paid back in cash because early-stage startups typically lack the financial means. Instead, the loan amount, along with any accrued interest, converts into company shares. The conversion rate can vary, generally offering a lower share price if triggered by the loan’s maturity, or a higher price during an equity round with new investors. This flexibility allows startups to manage cash flow while providing investors with a potential for equity gains.

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SAFE (Simple Agreement for Future Equity)

Contrasting with convertible loans, a SAFE is not a debt instrument but a contractual agreement where the investor receives future shares in return for their current investment. This agreement does not accrue interest and lacks a maturity date, which can initially seem advantageous. However, the final financial outcome may resemble that of convertible loans, as adjustments like valuation caps or discount rates are typically applied to balance the investor’s risk.

One of the defining features of SAFEs is their immediate conversion into shares at the next equity financing round, regardless of the amount raised or the duration until that round. This condition could potentially lead to premature equity dilution, impacting the startup’s control over its operations and governance.

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Making the right choice: Convertible loan or SAFE?

Although SAFEs are widely used in the United States and other common law jurisdictions due to their simplicity and investor-friendly terms, they pose certain challenges under Estonian law. The legal framework in Estonia for SAFEs is less developed compared to that for convertible loans, which are better understood by local legal professionals and offer more predictability in various legal scenarios, including bankruptcy.

Moreover, there are ongoing uncertainties about whether SAFEs can be classified strictly as equity rather than debt, which complicates financial reporting and auditing under Estonian regulations. Given these factors, Estonian startups might find convertible loans a more secure and manageable option. They provide a clearer path for both investors and founders to anticipate how investments and equity distributions will evolve, especially leading up to significant funding rounds.

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In summary, while SAFEs offer appealing simplicity and immediate equity conversion benefits, convertible loans currently offer a more robust and legally secure framework for startups in Estonia, making them a preferable choice for managing early-stage investments.

[1] A comprehensive collection of free sample documents, complete with explanatory footnotes, is available in the Model Documents section of Startup Estonia’s website (https://startupestonia.ee/resources).

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