Should SAFEs replace Convertible Notes?
You may have heard about the investment instrument Simple Agreement for Future Equity, otherwise known as a SAFE. SAFEs are just one of the many things Y Combinator is famous for. Y Combinator released their form documents for this instrument in late 2013, so they have been around for some time now. However, the startup community remains divided as far as whether this kind of financing is beneficial to entrepreneurs and investors alike.
SAFEs are investment instruments that represent a promise between the company and the investor. The investor hands the company cash in exchange for the promise of the company to issue stock to the investor when some agreed upon triggering event takes place. Typically, this triggering event is when the company experiences a subsequent priced round, but the triggering event can be any one of many events the company believes it will go through. Although this process sounds similar to that of a convertible note, SAFEs are not debt instruments. They do not have a maturity date, they do not collect interest, and they are not subject to some of the regulations imposed on convertible notes. Unlike convertible notes, SAFEs have some unique features.
One of the most attractive things about SAFEs is the range of options available to the investor and entrepreneur in negotiating the terms of the SAFE. Convertible notes come with red tape and many different terms to agree on. However, SAFE negotiations usually center on one term — the valuation cap. Since there is generally only one term to negotiate, it’s “safe” to assume that the amount of time and money the investor and entrepreneur must dedicate and spend on negotiations will be lower than a convertible note. Thus, allowing for some of that precious capital to be spent on what really matters – growing the business.
SAFEs not only can be used as a mechanism for seed capital, but the instrument can also be used, under the right circumstances, to help an early stage company with a significant short-term expense.
Not Debt; Therefore No Interest
Convertible notes come with a string of terms to negotiate such as conversion cap, discount, conversion on maturity, the sale of the company, and much more. SAFEs on the other hand typically only require negotiation of the valuation cap – the cap sets the highest value that may be used to determine the conversion price of the SAFE. Another important distinction is that SAFEs do not have a maturity date like convertible notes. If the company takes years to receive new funding, the SAFE owner still maintains their right to conversion. If the company goes public, has a change in control, or dissolves the SAFE holder still maintains their right to conversion. In each of those scenarios, the SAFE is designed to convert. However, it’s important to keep in mind these conversion terms are all negotiable.
It’s important to remember that SAFEs may not be suitable for all situations and that there are drawbacks to using a SAFE. SAFEs have the potential to dilute the founder’s ownership share in their own company, causing the founder not to be properly incentivized. Having too many SAFEs on the company’s capitalization table may cause future VCs to shy away from investing in the enterprise due to them having to be pressured to a higher valuation than they may want to give. Entrepreneurs often assume the valuation cap on the SAFE will become the floor for the future equity round, as well, which is not always the case.
Overall, the entrepreneur will want to evaluate their company’s particular position when deciding whether to use a SAFE or convertible note during the seed and later rounds. It’s important for the company to assess their situation, analyze the pros and cons of issuing a SAFE versus a convertible note, and to ask if the issuance of a SAFE aligns with the company’s long-term goals.