Recently, there’s been a few articles claiming that they’re bad for founders and other article rebuffing that notion. Techcrunch recently released a post entitled “Why SAFE notes are not safe for entrepreneurs” and claim they lead to more dilution than the founders had originally intended. The article goes on to state, “We have observed the following in our own recent direct experience investing in SAFE and convertible notes: that many founders have a tendency to associate the valuation cap on a note with the future floor for an equity round; that they further assume that any note discount implies the minimum premium for the next equity round; and that many founders don’t do the basic dilution math associated with what happens to their personal ownership stakes when these notes actually convert into equity.”
Y Combinator issued a follow-up piece called “SAFEs are not bad for entrepreneurs” where they make the point that you need to understand conversion and dilution which I agree with. Any founder raising capital that doesn’t know how much of the company they actually own once fully diluted isn’t paying attention. Jon Levy, author of the Y Combinator article goes on to say “The safe and its predecessor, the convertible note, have almost identical conversion features. So not understanding the effects of conversion is not a new problem that the safe specifically created. Rather, the ubiquity of using low-resolution fund-raising documents has created a larger universe of people (investors, founders, lawyers) grappling with conversion language.”
Whatever path you take to raise capital, make sure you know where you stand when all is said and done.
Here is a high level overview of SAFE’s:
Simplicity
Convertible notes can be complex. A SAFE is a 5-page document that was created for the purpose of simple seed investment. Because simplicity is one of its primary goals, SAFE offers a straightforward option: SAFE doesn’t carry an interest rate and doesn’t have a maturity date.
Conversion to Equity
Both SAFE and convertible notes allow for a conversion into equity. The difference here is that while a convertible note can allow for the conversion into the current round of stock, or a future financing event, a SAFE only allows for a conversion into the next round of financing.
Also, convertible notes typically trigger only when a “qualifying transaction takes place” (more than a minimum amount dictated on the agreement) or when both parties agree on the conversion. The SAFE can convert when any amount of equity investment is raised. This is nice for simplicity, but it doesn’t give the control to the entrepreneur, which is why the convertible note looks to be the best choice for seed investment in this category.
Discount
Both instruments carry a discount on the next round (or current round for convertible notes), so neither presents a clear advantage to seed investment in this category.
Valuation Cap
Depending on your negotiating skills and your company’s traction, you can get a SAFE or convertible note without a valuation cap. However, it’s pretty difficult to do in this environment with either instrument, so there is no clear winner for seed investment in this category.
Early Exit
If you’re looking for an early exit, convertible notes and SAFE offer similar payout mechanism in the event of a change in control (acquisition/IPO) before a conversion can occur. The SAFE is written to give the investor the choice of a 1x payout or conversion into equity at the cap amount to participate in the buyout.
In our experience, there are typically 2x payout provisions in a convertible debt agreement, which can still be written into SAFE agreements. Both options have seed investment advantages in this category.
Interest Rate
SAFEs are not a debt instrument. Instead, they are defined as a warrant. That means they do not carry an interest rate. Convertible debt, however, can carry a simple interest rate ranging from a 2% – 8% (most falling around 5%). Since most entrepreneurs don’t need another expense, a SAFE is the clear winner in this category.
Maturity Date
Since a SAFE is not a debt instrument, it does not have a maturity date. Convertible notes have a maturity date, and this can cause some issues when the maturity date comes to pass. Once the maturity is reached, an entrepreneur has two choices: pay back the principle plus interest (if the company has enough money to do that), or convert the debt into equity.
The latter is difficult to negotiate if the company isn’t doing well, and investors want their money back. It could even trigger a bankruptcy. Since that is the last thing an entrepreneur would like to deal with, the obvious choice from this perspective is the SAFE.
Source: InDinero, Link to Blog Post
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Author: Jared Toren
Jared Toren is CEO and Founder at Proper Wealth Management. Proper was born out of frustration with the inherent conflicts of interest at big brokerage firms influencing advisors to sell products that were not suitable for clients but profitable to the firm along with a consistently mixed message of who’s interest was supposed to be put first; the clients’, the firms’, shareholders or advisors.
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