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Safes and Convertible Notes
Part 3 of a series on ownership
This is part three of a series on ownership for founders. This isn’t a series on how to raise, but how to understand different owner perspectives, including your own.
Last time I talked about Understanding Angel Investors.
Continuing our walk up the cap table, I’m going to talk about Safes and convertible notes since they’re the most common mechanisms used by early stage companies to raise money.
Many founders do not understand why one type is better than another, or what problems they were designed to solve.
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A quick primer on convertibles
A lot has been written about Safes and convertible notes already. I am only going to focus on what I think is relevant for founders.
Safe - Simple Agreement for Future Equity
Safes are an agreement created by YC that allows investors to invest now and convert into shares later. It has basic protections for investors, but not as many as convertible notes or buying shares.
Safes is purpose built for early stage startups who expect to raise VC in the future.
They’re also standardized and this is their best feature. Eliminating weird/clever deal terms is good for both sides but also for future investors. When they see the word Safe they know exactly what they are dealing with.
This Safe is one of the forms available at http://ycombinator.com/documents and the Company and the Investor agree that neither one has modified the form, except to fill in blanks and bracketed terms.
(a key term in the Safe agreement)
Safes are founder-friendly because they get the upside of cash now without the overhead of shareholders, until later.
It’s possible for a Safe never to convert. Safes only convert when money is raised via issuing shares or there is a liquidation event. But there is no time limit or guarantee that it will happen.
In 2017, the SEC felt it needed to issue warning to investors:
Depending on its terms, a SAFE may not be triggered. Despite the identified triggers for conversion of the SAFE, there may be scenarios in which the triggers are not activated and the SAFE is not converted, leaving you with nothing. For example, if a company in which you invested makes enough money that it never again needs to raise capital, and it is not acquired by another company, then the conversion of the SAFE may never be triggered.
(see full SEC bulletin)
No, Safes are not un-safe. But founders should be aware that there are some things investors are giving up.
Convertible debt (or convertible notes) have been around much longer. They are used frequently in Angel investing and is favored in some industries. The best overview is still what’s in Venture Deals (chapter 8).
Like a Safe, a convertible note is an agreement to invest now and get shares later. All other things being equal, if a company raises their next round as planned a convertible note and a Safe can work exactly the same in terms of resulting ownership.
However, convertible notes are better for investors: there is a set timeline to convert, interest due and a repayment schedule.
Until they convert, investors are creditors which gives them superior claims on the company’s assets. They have a path to liquidity through interest and repayment that Safe holders do not. Having a maturity date gives them negotiating power with the company down the line.
One big disadvantage of convertible notes is the lack of standardized agreements. There are probably good legal reasons for that. But it means longer, more expensive agreements and the possibility of non-standard terms.
Side by side comparison
We aren’t convinced there is a definitive answer here; in fact, we are convinced that those who think there is a definitive answer are wrong.
- Brad Feld, Jason Mendelson, Venture Deals
Founders and investors can get quite definitive when it comes to the best way to raise money. But it’s not black and white. Founders and investors have different perspectives and not every company is on the same path.
I put together a comparison of the pros/cons of priced equity, Safes and convertible notes for three different scenarios:
Some companies have a faster path to profit or they aren’t dead set on VC. VCs may look down on this type of company but it’s one with high optionality for the founders.
Priced equity is a good choice if founders and investors are aligned about the plan. The legal bill can be high so this makes less sense for small rounds.
An investor’s perspective on Safe might be: “why would I invest in a Safe if you’re not sure you’ll raise more money?”
A convertible note would work well in this scenario. If there is a VC round the conversion works like a Safe. But if there’s not, investors can earn interest and be repaid. No harm, no foul. If convertible notes were more standardized this would be a no-brainer.
A priced round is a good choice unless founders and investors cannot agree on valuation. This “valuation gap” may be more perceived than real though. Many founders are not aware of how narrow the range is for valuations at the early stage, even taking into account industry.
Safes were invented for VC-track startups so they make the most sense here. However, for down markets, like the current one, delayed or cancelled rounds can cause problems. You might have to raise additional Safes to avoid triggering a conversion event at a valuation you can’t live with.
Cost and complexity are the biggest downsides of using convertible notes in this scenario. If the round is larger or the investors are more sophisticated, there’s no reason not to do it.
Raising money in between rounds is always tricky.
You can’t get a high valuation, otherwise you wouldn’t need to bridge. But a lower valuation risks dragging down the next round especially if you plan on raising soon. Many times founders just re-open the last round. More dilution but it doesn’t reset the clock.
Safes can be used to bridge if all previous funding was done via Safes. That’s called stacking Safes as mentioned before. But if the last round was equity it’s harder. Why would new investors agree to get future equity when there are already investors who got real equity?
Bridge rounds may be the area where convertible debt really shines.
Investors are already feeling jittery as they think about why this company needs a bridge vs a real round. The downside protections in a convertible note, interest and repayment, are added incentives to invest in this type of round.
This adds a much-needed sweetener to a bridge round and more founders should consider this tactic when bridging.
Founders should think of Safes, convertible notes and priced equity as valid options.
Speed and low cost are hallmarks of Safes. But they are really geared towards investors who are comfortable with “VC or bust.” Many fall into this category, but not all.
Convertible notes are good for investors who value more downside protection. Actually, it’s difficult to understand why an investor wouldn’t want that.
The most important thing to keep in mind is that investing via convertibles means a delay in being a shareholder. Often that serves founders well at the early stage. But the longer and more uncertain this “in between” stage is, the more problematic.