SAFE and Sound? A Primer on the new YC Docs

This is a guest post by Ryan Roberts of Roberts Foster LLP covering his thoughts on the recently released SAFE financing documents released by seed accelerator Y Combinator. Roberts Foster LLP is a LAUNCH DFW Community Champion.

A Primer on the SAFE Seed Financing Documents

Y Combinator (YC) recently released a set of seed financing documents called SAFE (Simple Agreement for Future Equity). Some background on seed financing structure and analysis of the newly-created SAFE documents can provide context and show that the seed financing trend continues to be startup-favorable.

Convertible Notes

The Structure

In a nutshell, convertible notes are loans that convert into equity upon specified future events. Most seed investors and startups prefer convertible notes to an equity round, as a convertible note round does not require negotiation of preferred stock terms, multiple documents, and the necessity of a charter amendment. This leads to faster closings and reduced transaction costs.

The most common debt-to-equity conversion event is a future round of equity financing with a minimum threshold of at least $500,000. We’ll call this a “Series A.” Each convertible note converts to the same series of stock your startup issues at a Series A.

The Discount and Price Cap

In order to compensate the convertible note investor for their earlier investment and therefore increased risk relative to the Series A investors, convertible notes offer a “Discount” to the Series A price per share paid by the Series A investors. The typical Discount is 20%. For example, if Series A investors purchase Series A shares at $1.00 per share, the convertible note holders would convert their debt into Series A shares at $0.80 per share.

As time has passed, startup costs have been reduced, allowing startups additional runway from a small seed round. Thus, startups can go 2+ years without needing a Series A round. Is a 20% discount, however, a fair premium for a convertible note investor 2+ years down the road? Sophisticated investors didn’t think so, and the “Price Cap” was born.

A “Price Cap” is the maximum pre-money valuation upon which the note will convert into equity. Thus, if a Series A pre-money valuation is $12.5 million and the note’s Price Cap is $5 million, the convertible note converts into equity at the $5 million valuation….a much better deal for the investor than a 20% discount off such Series A share price at a $12.5 million valuation.

Today, most convertible notes contain both a Price Cap and a Discount, and the investor applies either the Price Cap or the Discount when converting their debt into Series A shares. The investor uses the calculation that results in a greater number of Series A shares.

Convertible Equity

A recent addition to the seed financing arsenal, convertible equity is essentially a convertible note without the debt features, i.e. no interest and no maturity date. But, the economic terms of conversion (Price Cap and Discount) typically still apply.

Convertible equity alleviates a primary concern of convertible notes – repayment if a future round of financing or a sale of the startup does not occur prior to the maturity date. Additionally, a couple of famous incubators have started to use convertible equity as a partial way to finance their portfolio companies. Issuing debt can also involve regulatory issues, such as the California Finance Lenders Law, which are avoided through the use of convertible equity. I’ve also had a few clients use convertible equity immediately prior to a Series A round.

SAFE – Convertible Equity Document Set

SAFE is convertible equity, and YC has provided 4 different document sets:

(1) Price Cap and Discount. This version of SAFE is convertible equity with a Price Cap and Discount.

(2) Discount. This version of SAFE is convertible equity with only a Discount. (Note that this version has no threshold amount that the startup must raise to trigger the conversion.)

(3) Price Cap. This version of SAFE is convertible equity with only a Price Cap. (Note that this version has no threshold amount that the startup must raise to trigger the conversion.)

(4) Most Favored Nation (MFN) Provision. This version of SAFE is a convertible equity with no Price Cap or Discount. But if the startup subsequently issues SAFE with provisions that are more advantageous relative to current SAFE investors, this version of SAFE can be amended to reflect the terms of such subsequent issued SAFEs. (Note that this version does not automatically convert into shares unless the amount of Series A raised is at least $250,000).

One thing I do like about SAFE is that it attempts to standardize “liquidation preference protection” for startups. Basically, through Price Caps and Discounts, investor liquidation preferences can get out of whack, resulting in a liquidation preference exceeding the investor’s original investment amount. For more details on this potential issue, I wrote a blog post a year ago on this subject and the SAFE documents incorporate one of the solutions.

Pros and Cons of Convertible Equity vs. Convertible Notes

Interest

Since it is not debt, convertible equity does not accrue interest. While interest is not a big deal for east or west coast investors, even a 2% interest rate can be dilutive depending on how much capital your startup ultimately raises.

No Default

Since SAFE has no maturity date, in theory SAFE can remain outstanding without the need to extend. A SAFE is designed to terminate upon the first to occur of: a SAFE holder receiving stock or cash, an equity financing, a sale of the startup, an IPO, and a dissolution. In a dissolution, any money that the startup has to distribute would be distributed to SAFE investors before any money is allocated to holders of common stock.

I’m not sure the maturity date is ever a problem for startups, as I’ve never had a client have an issue with it. Paul Graham doesn’t believe this is an issue either. Typically, the convertible note investors and the startup work out an extension of the maturity date or a conversion to equity.

Balance Sheet Issues; Director Duties

If your startup deals with a bank, convertible notes could be an obstacle to secure additional debt financing. But, that assumes banks are willing to loan money to an early-stage tech startup. Furthermore, being “insolvent” thanks to a bunch of convertible debt can create issues for a startup’s directors and executive officers.

What Does this Mean for the DFW Startup Community?

DFW vs. The Valley

I think most of you would agree that “the Valley” is a different universe for funding than DFW…and YC can be a different universe than the Valley. In other words, SAFE may not even take off in the Valley, much less here.

Too Startup-Favorable?

I recently had a “Valley VC” push back on convertible equity and opt for a convertible note. Maybe we’re just too early in the convertible equity adoption phase, but some early criticism is that SAFE is too startup favorable. Don Dodge says that SAFE is “1 sided in favor of startups”.

“But what do I get?”

If you’ve attempted to raise money via convertible notes in DFW, you know that local investors always ask “but what do I get percentage wise”? SAFE is not going to give them a fixed-percentage-of-the-company answer. You’ll still have to explain the potential conversion triggers and economic terms to them, as you do with a convertible note structure.

Interest

While west and east coast VC’s and angels tend to be fine with 2% interest on a convertible note, 5-8% seems to be the local interest rate. Thus, not having any interest may be more of an issue for local investors compared to non-local investors.

Conclusion

SAFE is not a solution to a problem – it’s a refinement or attempted standardization of an existing seed investment structure. Regardless, you should know your options when raising capital. At this point, I plan to advise clients to use convertible notes instead of SAFE, barring exigent circumstances.

 

About the Author

Ryan Roberts represents startup companies through all phases of their life cycle. His blog, startuplawyer.com, was recently named one of the 100 Best Websites for Entrepreneurs by Forbes.