Recently made available by Y Combinator, the SAFE investment instrument is intended to improve on the highly popular convertible note used by startups during the seed stage or as a short-term bridge between equity rounds. SAFE stands for “simple agreement for future equity”. The purpose of this blog post is to generally review the elements that make up a SAFE investment and compare them to a convertible note. For those not already highly familiar with convertible notes, see my blog post title “Convertible Note Basics” for a primer.
Before jumping into the review and comparison, I’ll say that I generally like SAFE and would not have a problem investing using it, either as an investor or recommending it to a startup I advise. I can’t yet say that I prefer it over a convertible note. Instead, I see both as viable investment instruments for seed stage investing, each with their own pros and cons. I’m not quite sure I like the name because all seed stage investing is highly risky but hopefully accredited investors already know that. Coming up with an acronym for SIMPLE might have been more appropriate but I’m at least happy to see another viable seed stage investment instrument in the market.
SAFE is a short, 5-page investment document that is intended to be simple to understand and convenient to administer. It’s not a debt instrument but rather investments via SAFE show up on the company’s capitalization table (cap table) like other convertible securities (ie – warrants, options). So in this regard, SAFE provides investors the opportunity to convert their investment to equity at a point in the future when an equity round is raised and preferred shares are issued. SAFE has provisions for early exit (change of control) or dissolution of the company and it also has preferential provisions for investors such as discounts and valuation caps. But one thing SAFE doesn’t have is a maturity date (remember, it’s not a debt instrument), so there is a possibility that it never converts to equity and there’s nothing in the terms that call for the investment to be repaid to the investor.
Comparing SAFE to a Convertible Note
Simplicity- Both are fairly simple to understand but since SAFE isn’t a debt instrument and since its creators took special care to keep it ultra simple, it literally fits on five pages.
Conversion to Equity- Both convert to equity when a future priced/equity round is closed. However, convertible notes stipulate a minimum amount of money to be raised in a future equity round before being considered a “qualifying transaction” that triggers conversion. SAFE investments convert with any amount raised in an equity round, which is definitely a simpler approach and something that should appeal to investors since they don’t have to worry if/when the company will raise enough money to be considered a “qualifying transaction”.
Discount- Both offer a discount to early investors, which is applied to the valuation used during the future equity round.
Valuation Cap- Both offer the investor the choice of the discounted valuation (using the stated discount) or a pre-negotiated valuation cap, whichever is more favorable at the time of conversion. (See my related post titled “Justifying the Cap Amount in Your Convertible Note“)
Early Exit- Both offer similar payout mechanisms if a change of control event (ie – acquisition) happens before a natural conversion to equity. Note that the SAFE documents are written to give the investor a choice of a 1X payout or conversion to equity at the cap amount and then participation in the acquisition along with other equity holders. Since many convertible notes offer a 2X payout option, this is one thing I expect to see investors negotiate into the SAFE document.
Interest Rate- Convertible notes have them since they are debt instruments but SAFEs don’t. I’m not sure seed stage investors care much about the interest they accrue on convertible notes, but the truth is a note that carries an 8% interest for 18 months before converting can accrue a non-trivial amount of interest that also converts to equity along with the invested principal.
(Advantage: Convertible Note)
Maturity Date (Term) – Convertible notes have them since they are debt instruments but SAFEs don’t. To evaluate this difference, you have to think about two scenarios. In a case where the company is doing well but just hasn’t needed to raise additional funding as soon as they thought, the company and the investors usually have two choices. They can either agree to extend the maturity date on the convertible note rather than force a payoff of the note or some convertible notes have an option to convert to equity using the valuation cap amount as the pre-money valuation if the maturity date is reached. In a case where the company is struggling and likely not going to survive, the convertible note investors can try to force a payoff of the note, but the final result probably isn’t going to be very exciting for either party. Since the SAFE doesn’t have the concept of a maturity date or term, possibly the biggest risk is with companies that do so well that they never need to raise an equity round and the SAFE investments never convert naturally. But a well-performing company like this isn’t just going to leave their seed stage investors hanging and surely will figure out a way to convert them to equity – it’s just not certain at all how fair the investors will feel the terms of conversion are because the company holds all the power in such a negotiation.
(Advantage: Convertible Note)
Company Business Structure- Often times, companies raising seed stage money are still in LLC formation (rather than a C-corporation). Since a convertible note is a debt instrument, it is usually fine for an LLC to use. However, SAFE appears to require incorporation since the value of the SAFE investment is reflected on the cap table like warrants or stock options. I’m guessing this could affect 50-75% of startups that are still less than $500K in revenue and haven’t otherwise had a reason to convert to a C-corp.
(Advantage: Convertible Note)
I can’t suggest to simply add up the scoring from my assessment above to determine a “winner” because each company seeking seed-round investment is so different and with many factors playing an influence. So instead, entrepreneurs should assess their current situation, expected future path, and investors’ interests and concerns before deciding which instrument is best to use. Having said that, above is a quick summary graphic based on my assessment.
There are a couple of other miscellaneous points worth mentioning about SAFE:
- There are questions as to the effect SAFEs will have on the Fair Market Value of the company (used to set the current share price). Should raising money via SAFE trigger a 409A valuation or not?
- Interestingly, the sale of Common stock to raise money doesn’t naturally trigger conversion for SAFE investors. This is the same with most convertible notes but they have maturity dates that force some sort of action eventually.
- If the startup does well and never needs to raise money via the sale of Preferred shares, they could start issuing dividend payments to Common shareholders and SAFE investors wouldn’t be entitled to participate in those payments.
- Following a conversion to equity, certain rights granted to SAFE investors are based on their original investment amount. This is done via a separate series of preferred stock, commonly called “shadow” or “sub-series” preferred. The rights affected include the liquidation preference and dividend rate. This is necessary due to the discount or if the valuation cap comes into play, both of which give the SAFE investor a preferential price per share. Seems fair and isn’t something most convertible notes take into account.
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