Written by Mark Lupa
Co-Founder & General Partner,
Buff Gold Ventures
The use of SAFEs (Simple Agreement for Equity) in early-stage rounds, particularly seed or pre-seed, has become commonplace over the past 10 years.
This investment instrument appears to have been created by attorneys affiliated with Y Combinator, the California based startup accelerator that has helped many companies move from concept to company. It is preferred by founders because of the simplicity of concept and low document costs. Like convertible notes, it also avoids having discussions about company valuation, and pushes equity dilution in the company to a date in the future.
The main difference between a SAFE and convertible note is that 1) notes have terms and an end date by which company and investor both agree something should happen, and 2) notes have an interest rate so that invested capital can realize a nominal return over the time it is held and put to work. A little more detail on these differences below:
Length of Term:
SAFEs are open ended, with no end date
Convertible notes have a term by which time the capital is either converted into equity or repaid, putting a timetable on company development expectations
Return on Investment:
SAFEs have zero return until converted, and then it is typically a flat 20% upside, regardless of how long the money has been held
Convertible notes also provide the 20% upside on conversion, but in addition provide a small return during holding period based on an interest rate
Conversion Cap:
This is usually present in both forms of investment - it represents the high side of a reasonable valuation at the time of the note
This is not a valuation of the company at the time of investment, nor is it a valuation of the company in 12-18 months, when the company has made progress and seeks an equity investment
The Conversion Cap was added in order to assure investors that the valuation their money will convert into would not exceed a reasonable seed stage value
Buff Gold Ventures as a firm typically does not invest in SAFEs, for several reasons: A SAFE is not an equity security in a company, nor is it a loan. SAFE investors are not protected by state corporate or federal security laws, and if the qualifying equity round never closes, investors may get nothing or perhaps only their money back. More realistically, the qualifying round may occur years after the initial investment, meaning that investor money is at risk over a long time period. Over this time the company gets to use the SAFE capital to build value, with investors only realizing a 20% increase in their investment value, regardless of the time it was held, or the progress made.
As a seed and early-stage investor, we view this as undue risk and inadequate return to investors who typically are taking the highest risk by putting capital into companies long before proof of concept, let alone revenue. Like other investors that focus on early-stage investments, we are more sensitive to this because we rely on early-stage investment to capture sufficient value to make our funds successful. We believe that the VC-entrepreneurial ecosystem only works when investment terms work for everyone – founders, management, and venture capital.
Convertible notes have been used for decades as “bridge” investments, traditionally to keep a company afloat between later rounds but most recently as the first money into a seedling company. This money is often provided by smaller VC firms or wealthy individuals, and has usually been invested under the premise that the company needs a small amount of capital to reach a milestone or to attract larger investors into a Series A round. The term on these loans is usually 12-18 months, with a small interest rate and a 20-25% discount to convert into the next round. If at the end of the note term the company has still not raised a qualifying round, then the debt holders can extend or modify the terms (most common), ask for repayment (seldom used as there is usually no money available), or do nothing.
One argument for SAFEs is that they are simple documents and thus reduce costs. In reality the difference in cost between convertible notes and SAFEs are minimal. Our firm maintains a short convertible note template of 3-4 pages that we use to create our own notes. We can easily draft one with terms that reflect industry standards. Company counsel may have some tweaks to language or terms, but in general this does not amount to a significant cost.
In summary, investors are putting money to work in these companies for the equity upside. So, as long as the time between investment and conversion is reasonable (generally 8-18 months), then the interest rate return really doesn’t mean much. The important terms are the time between investment and conversion to equity and the conversion discount. This becomes particularly important when convertible notes, or SAFEs, are stacked in series as a mechanism to keep the company alive without a priced equity round.
