Seed Investing: Understanding the Landscape - Part III

In this final installment of our series on seed instruments, we explore the Simple Agreement for Future Equity. 

Startup accelerator Y Combinator (YC) introduced a new seed-stage investing tool, safe—an acronym for Simple Agreement for Future Equity—in 2013 to provide an alternative to convertible notes. A safe is convertible equity, a concept initially introduced by the Founder Institute to address some of the problems with convertible notes. Unlike a convertible note, a safe is not intended to be a debt instrument. Instead, it is more like a warrant, because the investor gets a right to equity in a future round of financing.

YC has made documents for four types of safes available: (1) a safe with a cap and no discount; (2) a safe with a discount, typically of 15%-20%, and no cap; (3) a safe with a cap and a discount, either of which can apply at the time of conversion; and (4) a most favored nation (MFN) safe, which has no cap and no discount—this option may be chosen so that safe investors get any advantageous terms (discounts and/or caps) that may be negotiated in a future safe round.

One of the key features of a safe is that it converts to preferred stock with the same rights as the preferred stockholder except with respect to liquidation preference.  In order to avoid providing the safe investors with “excess” liquidation preference, the safes provide that the investors receive a shadow series of preferred, with all other terms being the same as the new security, except that the aggregate liquidation preference equals the aggregate amount of the safes converting. 

Pros of Safe

1. Efficiency and cost reduction. The standard safe documents are simple, five-page documents without room for much negotiation (the main points of negotiation are usually cap and discount). This means that the process of investing via safe is much quicker and cheaper than with convertible notes or Series Seed. Safe investors will get the same rights as preferred stockholders in the next round of financing (except their liquidation preference will equal the aggregate amount of the safes), so they rely on the investors in the next round to negotiate these terms.
   
   A safe, however, does not have the concept of a “major investor” threshold, so, by default, safe investors get a pro rata right irrespective of their investment amount. If the founders want to limit who gets pro rata rights in future financing rounds, they can add in the language suggested in the YC Safe Primer.
2. No maturity date or interest. One of the main reasons for founders to move away from using convertible notes is that as a debt instrument, a convertible note has both a maturity date and an interest rate. The maturity date acts as an artificial clock that hands the leverage back to the investors when it comes time to extend the maturity date. As convertible equity, the safe has no maturity date and so theoretically, if the company does not raise an equity round or does not get acquired or dissolved, the company has no obligation to pay anything to the safe investors.
   
   Investors want a maturity date because it provides them and the company with a checkpoint at which to evaluate progress and growth. Also, not having a maturity date could be bad for investors if a company starts generating revenue, but does not raise an equity round. The company might begin issuing dividends to the equity holders, but the safe investors will not be able to participate in these distributions. In this case, though, it is more likely that the investors and company will negotiate some return to the investors.
3. Pro-founder terms.
   1. 1X liquidation preference: A safe converts into safe preferred stock—also known as shadow preferred stock—at the time of the next round of equity financing. The documents make clear that safe preferred stockholders will have the same rights as preferred stockholders, but the liquidation preference, conversion price and dividend rate will be calculated on the basis of the amount invested by safe investors. This means that safe investors get a simple 1X liquidation preference—the safe documents do away with the liquidation windfall that is usually part of a convertible note.
   2. 1X return in early exit: If the company exits before the safe converts to equity, the investors can either take a 1X return or convert to equity at the cap amount. Convertible notes, on the other hand, typically have a 2X return in the case of an early exit. Since series seed is straight-up preferred stock, the series seed investors also get 1X return in an early exit.

4. No current valuation. As in a convertible note financing, in a safe financing, the company and investors do not have to agree to a company valuation, which could have potential implications for 409A valuations and employee stock options. However, a safe with a cap is effectively a maximum valuation for the investors; the no current valuation only holds true in a no cap, discount safe.
5. No investor board seat or control provisions. Safe investors do not get board seats or veto or control rights. This allows founders to retain control of the company instead of having to assign board seats—possibly to people who might end up owning only a small percentage of the company—at an early stage.
    
6. Fundraising flexibility. In a safe financing, a company and investors can close the deal as soon as they agree on basic terms, instead of waiting to “fill out the rest of the round.” This flexibility adds speed, and also—as in a convertible note financing, allows the founders to raise safes with different caps and discounts on a rolling basis.
   
   On the other hand, fundraising can be a very time-consuming process, and founders may want to close the round and move back to focusing on the product and the company. Another possible disadvantage is that the amount of safe shadow preferred series stock will increase with each variation in cap and/or discount, which will complicate the cap table. Although this is not a reason not to get better terms or raise more money, it can eventually add to legal costs.

Cons of Safe

1. They only work for C-corps. A safe financing works only if a startup is incorporated as a C-corp. Unlike in convertible note financing, safes do not work for an LLC. A startup organized as an LLC that wants to do a safe financing has to convert to a C-corp, which adds some time and cost to the process, but really is an inevitable transition for most companies as they grow and raise subsequent rounds of funds. It may even be cheaper and easier to go through the conversion at an earlier stage. Read more about the type of entity to create for your startup.
2. Limited adoption by investors. Safes have become widely used for early-stage seed investments, usually of less than $1 million. For anything over $1 million, investors often want the protective provisions, board seats and other safeguards that are included in other types of financing. Safes are also more prevalent on the West Coast than on the East Coast, where seed investors sometimes prefer to use the more traditional convertible notes structure for investments.

In case you missed it or want a review, in Part I we looked at convertible debt and in Part II we explored Series Seed.