Introduction
For early-stage startups raising their first rounds of capital, convertible notes and Simple Agreements for Future Equity (SAFEs) have become the instruments of choice. They are faster to document than a priced equity round, cheaper to negotiate, and avoid the need to agree on a company valuation at the earliest — and most uncertain — stage of a business.
Both instruments are widely used in Hong Kong's startup ecosystem, and both raise a number of important legal considerations under Hong Kong law that founders and investors should understand before signing. This guide sets out the key features of each instrument, how they compare, and the specific Hong Kong law issues that arise.
What Is a Convertible Note?
A convertible note is a form of debt that converts into equity upon the occurrence of specified trigger events — most commonly a qualifying financing round (such as a Series A), a sale of the company, or at maturity. It combines features of a loan (principal amount, interest, maturity date) with the economic dynamics of an equity investment (conversion mechanics, valuation cap, discount).
The key commercial terms of a convertible note are:
- Principal amount: The amount invested, which accrues interest and converts into equity.
- Interest rate: Typically 5–8% per annum, accruing on the outstanding principal. Interest usually converts alongside principal at the conversion event rather than being paid in cash.
- Maturity date: The date by which the note must either convert or be repaid. Most early-stage notes have 12–24 month maturities. At maturity, the investor may demand repayment or agree to extend.
- Conversion discount: A percentage discount (commonly 15–25%) applied to the share price at the qualifying financing round, rewarding the early investor for bearing greater risk.
- Valuation cap: A maximum pre-money valuation at which the note converts, protecting the investor if the company's valuation rises sharply before conversion. The note converts at the lower of the capped price and the discounted price.
- Qualifying financing threshold: The minimum amount raised in the next round that triggers automatic conversion (e.g., HK$8 million or USD 1 million). Rounds below the threshold may not trigger conversion.
- Most Favoured Nation (MFN) clause: Gives the noteholder the right to adopt any more favourable terms offered to subsequent noteholders before a conversion event.
What Is a SAFE?
The SAFE (Simple Agreement for Future Equity) was introduced by Y Combinator in 2013 as a simpler alternative to convertible notes. Unlike a convertible note, a SAFE is not a debt instrument — it carries no interest, has no maturity date, and does not create an obligation to repay. It is an agreement by which the investor pays money now in exchange for the right to receive equity in a future financing round (or on a liquidity event).
SAFEs use the same basic conversion mechanics as convertible notes (valuation caps, discounts, MFN clauses) but eliminate the complexities associated with debt: no interest accrual, no maturity pressure, and no debt obligation on the startup's balance sheet.
The four standard Y Combinator SAFE variants are:
- Cap, no discount: Converts at the capped price with no additional discount.
- Discount, no cap: Converts at a discount to the next round price with no valuation cap.
- Cap and discount: The investor benefits from both protections, converting at the more investor-favourable of the two.
- MFN, no cap or discount: The SAFE adopts whatever terms are offered to future investors.
In Hong Kong, SAFEs are used but less universally than in the US market. Some local and regional investors prefer the structure of a convertible note with its debt character, while others (particularly those with US investment experience) are comfortable with SAFEs.
Convertible Note vs SAFE vs Priced Round: A Comparison
The choice between a convertible note, a SAFE, and a priced equity round involves trade-offs across cost, speed, and legal complexity:
- Priced equity round: Requires valuation agreement, detailed term sheet, shareholder agreement or shareholders' deed, constitutional amendments, and regulatory filings. Takes 4–8 weeks (at minimum) and involves meaningful legal fees. Appropriate for Series A and beyond where valuation is more established.
- Convertible note: Faster and cheaper than a priced round. Creates a debt obligation that appears on the balance sheet. More familiar to traditional investors. Maturity date creates a hard deadline that can create pressure on the company.
- SAFE: Fastest and simplest instrument. No debt on balance sheet. No maturity date. Administratively lighter. May be less familiar to non-US investors and creates dilution uncertainty for founders (since the full equity impact is only known when conversion occurs).
Hong Kong Law Considerations
Are Convertible Notes Securities or Debentures?
Under the Companies Ordinance (Cap. 622), a debenture includes debenture stock, bonds, and any other instrument creating or acknowledging indebtedness. A convertible note issued by a Hong Kong-incorporated company is likely to constitute a debenture. This has several practical implications:
- Issuance of debentures by a company to the public may require compliance with the prospectus requirements under the Companies Ordinance and the Securities and Futures Ordinance (SFO). Startups issuing convertible notes should ensure the issuance falls within available exemptions — for example, the professional investor exemption or the small offer exemption — to avoid triggering prospectus obligations.
- A register of debenture holders may need to be maintained.
- Security over assets (if any) must be registered with the Companies Registry within one month of creation.
Are SAFEs Securities?
The regulatory classification of SAFEs under Hong Kong law is not settled. Unlike convertible notes, a SAFE is not a debt instrument and may not be a debenture in the traditional sense. However, it may constitute a form of interest in a collective investment scheme or a structured product depending on how it is structured and marketed. Founders should take legal advice before issuing SAFEs widely, particularly if approaching a broad investor base or investors other than close professional contacts.
Stamp Duty
Stamp duty under the Stamp Duty Ordinance (Cap. 117) applies to instruments that transfer Hong Kong stock. A convertible note issued by a Hong Kong company is typically a debenture and not subject to ad valorem stamp duty on issuance (debentures are generally exempt from transfer duty unless they have equity-like features on transfer). However, on conversion of the note into shares, the resulting share transfer or allotment agreement may attract stamp duty at 0.2% of the consideration (shared equally between buyer and seller at 0.1% each). Founders should factor this into the mechanics of conversion, particularly where large amounts are converting.
Cap Table and Dilution
Both convertible notes and SAFEs defer the dilution impact on founders until conversion. This creates a risk that founders underestimate the dilutive effect of multiple instruments converting simultaneously at a qualified financing round. Where a startup has issued several tranches of convertible notes or SAFEs with different caps and discounts, the dilution at Series A can be substantially greater than expected. Founders should model the fully diluted cap table on a worst-case basis before issuing additional instruments.
Companies Registry Filings
Allotment of shares on conversion of a convertible note or SAFE triggers filing obligations under the Companies Ordinance. Form NSC1 (return of allotment) must be filed with the Companies Registry within one month of allotment. Founders should ensure their company secretary is briefed on conversion mechanics to ensure timely compliance.
Key Negotiation Points for Founders
When negotiating convertible notes or SAFEs with investors, founders should pay particular attention to the following:
- Valuation cap level: A low cap creates significant dilution risk at conversion. Founders should negotiate a cap that reflects a reasonable range of outcomes for the next round.
- Qualifying financing threshold: Setting the threshold too low means the note converts on a small bridge round. Setting it too high may mean it never converts. The threshold should reflect the intended next round size.
- Change of control conversion: Many notes provide for conversion at a discount on an acquisition. Founders should understand the mechanics carefully — in some cases, a low cap can result in the noteholder receiving a disproportionate share of sale proceeds.
- Pro-rata rights: Investors may request the right to invest pro-rata in the next priced round. This can complicate round dynamics if the investor pool is large.
- Information rights: Noteholders often request quarterly financials or notice of material events. Founders should keep these obligations manageable, particularly where there are multiple noteholders.
Key Negotiation Points for Investors
From the investor's perspective, key protections include:
- Valuation cap: Ensures the investor benefits meaningfully if the company's value rises substantially before the next round.
- Discount: Provides a baseline return on early risk even if the company's valuation does not rise sharply.
- MFN clause: Protects the investor against being disadvantaged by better terms offered to later noteholders in the same round.
- Maturity protection (for convertible notes): Ensures the investor has recourse if the company fails to raise a qualifying round within the expected timeframe.
- Conversion mechanics on M&A: The note should address what happens to the investment if the company is acquired before a conversion event, including a minimum return provision (e.g., 1x or 1.5x the invested amount).
Common Pitfalls
The most common mistakes founders make with convertible notes and SAFEs include:
- Stacking too many instruments: Issuing multiple tranches with different caps and discounts creates a complex conversion scenario and can result in unexpected dilution at the Series A. Founders should consider consolidating tranches where possible.
- Ignoring the maturity date: Founders who fail to raise a qualifying round before the convertible note matures face pressure to repay or extend. Building in extension mechanics — or choosing a SAFE where maturity is not an issue — can reduce this risk.
- Inadequate cap table modelling: Founders who do not model the full dilutive impact of conversion at different valuations may be surprised at Series A. Legal and financial advisers should help founders build a fully diluted cap table model before issuing instruments.
- Using US-law forms without localisation: The Y Combinator SAFE form is governed by California law and references Delaware corporate law concepts. Using it without modification for a Hong Kong company creates mismatches that could complicate enforcement. A Hong Kong-specific form should be used.
Practical Recommendations
For most Hong Kong startups raising a pre-seed or seed round, a SAFE or convertible note with a valuation cap in the range of the target Series A valuation — and a discount of 15–20% — is appropriate. The choice between the two instruments will depend on investor preference and whether the startup's investors are comfortable with a non-debt instrument.
Founders should:
- Engage a Hong Kong-qualified lawyer to prepare or review the instrument before signing.
- Ensure the instrument is properly issued and, for convertible notes, registered with the Companies Registry if security is granted.
- Model the full dilution impact at multiple conversion scenarios before issuing instruments.
- Confirm that the issuance falls within available exemptions from Hong Kong's securities law prospectus requirements.
How Alan Wong LLP Can Help
Alan Wong LLP advises Hong Kong startups, founders, and early-stage investors on convertible note and SAFE documentation, equity fundraising structures, and the regulatory considerations applicable to pre-seed and seed-stage capital raising. We prepare Hong Kong-law convertible note agreements and SAFE instruments, advise on cap table structuring and dilution modelling, and act for both founders and investors on early-stage transactions.
Whether you are raising your first round or investing in early-stage companies, we can help you structure the transaction efficiently and on terms that protect your interests.
