SAFEs are not bad for entrepreneurs

https://blog.ycombinator.com/safes-are-not-bad-for-entrepreneurs/

by janober • 9 years ago

157 112 9 years ago

blog.ycombinator.com

thefahim3• 9 years ago

The cost of priced rounds is often brought up as a reason to choose a SAFE. Why are priced rounds so expensive in the first place?

SandersAK2• 9 years ago

Priced equity means you're actually transferring ownership of shares. It's going to involve a lot of diligence and negotiation around rights, etc.

The short answer: lawyer time.

thefahim3• 9 years ago

All of this seems automatable with software as long as everyone follows conventions (as they do with SAFEs).

taylorwc• 9 years ago

Short answer: attorneys.

When you do a priced round, you have to go in and change many aspects of a company's legal structure. For example, the documents drafted in a priced round may include amendments to the charter, a voting agreement, a stock purchase agreement, a right of first refusal agreement, a shareholder agreement. Drafting the legal docs for a convertible note or SAFE is less intensive and time consuming.

jasonlaramburu• 9 years ago

A couple other things: the level of due diligence is typically higher in a priced round, which eats up lawyer time. Also it's customary (for reasons no one can clearly articulate) that the investor(s) legal fees are paid by the startup in addition to its own.

thefahim3• 9 years ago

Amendments, right of refusal, etc do not happen in SAFE rounds. Why do we assume they should happen in a priced round? Seems like all these documents have been generally standardized so the cost should be the same barring investors asking for extra rights in a Series A.

staticautomatic• 9 years ago

People seem to forget that you can "price the round" without selling priced shares and incurring all the associated headache/expense if you just treat your convertible note like the warrant that it is and have it convert at a predetermined price. I've done it several times myself.

justin• 9 years ago

At Atrium LTS we are working on ways to reduce the cost of priced rounds! Please get in touch if you'd like to learn more.

oyeanuj2• 9 years ago

We'd love to! What's the best way to get in touch? (My email is in my profile)

bmh_ca5• 9 years ago

The safe and its predecessor, the convertible note, have almost identical conversion features

A SAFE _is_ a convertible note, with standardized language.

philip1209• 9 years ago

I believe they are different in that a SAFE does have interest.

CyrusL• 9 years ago

Nope, a note has interest and a SAFE doesn't.

bmh_ca5• 9 years ago

It is not necessary for a promissory note to bear interest. As in the case of the SAFE, that provision is simply absent.

elmar2• 9 years ago

The SAFE doesn't have interest and no maturity date.

kirsty2• 9 years ago

Safes and convertible note are both types of Convertible Securities. Ie they each convert into shares at a future date, usually at a priced round.

A convertible note is structured as debt - there is interest earned until it converts and a maturity date. There are also terms about repaying the debt.

A safe is not debt - it does not have a maturity date and interest does not accrue.

So referring to a "Safe Note" is non-sensical because there is no such thing.

bmh_ca5• 9 years ago

The safe is just a convertible note with the "event of default," interest, and maturity date provisions stripped out.
- Carolynn Levy (inventor of the SAFE)

edit ... You could argue it's no longer a convertible note with those provisions taken out, but I'm not sure how much mileage you'd get with that argument.

bmh_ca5• 9 years ago

For those interested in reading further, here is an on-point interview with Carolynn Levy:

http://abovethelaw.com/2015/01/innovation-more-than-another-...

oyeanuj2• 9 years ago

and the industry standard is that companies pay for BOTH their own legal counsel and the investor’s legal fees.

Serious question - how is this still the case, or make any sense? Wouldn't it be in the investor's interest that the company doesn't spend $60K out of their raise on this, and instead on hires, product, etc?

And given how standard a process this must be for every VC firm, I imagine they would have a well-negotiated rate, which for them is an incremental cost of investing?

I'd like to believe that there are firms out there that don't do this, and that this is turns out to be some sort of advantage for them (a form of founder-friendly/company-friendly, if you will).

anotherfounder16• 9 years ago

The most charitable explanation I can think of is that this is a relic of old times, and that is changing. I know of founders who have insisted on this being paid by the VC, and successfully gotten so.

But I'd also like to know how standard/non-standard this is.. and why is it even the case in the first place?

Given how Fred Wilson (and others) talk about not liking SAFE, they really should then make it easier to do priced rounds without putting the burden on founders.

arohner3• 9 years ago

why is it even the case in the first place?

1) Because VCs were working on 'fixed income' 2) because they could. The standard deal historically is "2 and 20", i.e. the VCs get paid 2% of the fund raised per year, and the first 20% of the profit. That 2% is used to pay for salary and office space, and doesn't increase until you raise a new fund, and the 20% isn't realized until the fund ends in 10 years. So pushing the cost onto the startup saves them a decent amount of money when you're doing dozens of deals a year.

harryh3• 9 years ago

No, it would not be in the investors best interest to make that change. Under the current system all of the money spent is used to buy shares in the company. Under a system where the VC firm was responsible for their own legal fees then $25k (or whatever) would go directly to the lawyers instead of buying shares so they would end up with a bit less ownership.

EDIT: To be clear I'm not saying that I am in favor of the status quo. I am not. I'm just saying that it is understandable given the incentives of VC firms.

anotherfounder16• 9 years ago

It really seems short-sighted, since the focus should be on making sure companies have enough runway, comfortable and focused on product. For an early stage startup, $25K- $60K can be an extra part-time/full-time (depending on location/function) employee.

acjohnson55• 9 years ago

...of a financially healthier company!

But I suppose it's really kind of a matter of accounting. As long as the outlay of the investors is equal in both scenarios, the post-money situation should be approximately the same.

That said, in reality, the VCs probably have a better understanding of the real costs of the fundraise, so I can see the argument that they'd be best served in the long-run by minimizing surprises for their portfolio companies.

technotony• 9 years ago

Also, then the $25k would come out of the management fee rather than the LP's capital. Even less incentive for the fund manager to go this route!

arohner3• 9 years ago

The VCs aren't the investors here.

There are 3 parties, the startup, the VCs and the LPs. The LPs are generally pension funds, college endowments, and sovereign wealth funds, i.e. institutions who can write $10M-$100M checks. The VCs are their agent, like a real estate agent helping you buying a house.

While VCs put their own money into the fund, generally the vast majority of the fund money comes from the LPs. The VCs get paid 2 and 20, 2% of the fund per year for things like salary and rent, and the first 20% of profits from the fund when it ends, in 10 years. Because of this structure, they don't get to treat the fund money as their own personal piggybank.

No matter who pays, the cost of a deal is going to be <money startup receives> + <startup legal costs> + <VC legal costs>.

Raising the cost for the VCs, without changing 2 and 20 just results in increased costs for the VC. Paying their own legal costs means they'll do fewer deals, with larger check sizes.

jalonso5102• 9 years ago

VC's typically get to charge fees on capital they deploy, not just what their institutional investors have committed to their fund. So in theory, while they could be more transparent by reducing the amount of their investment by the amount of their legal fees and then paying them out of pocket, they prefer to instead deploy that money to the portfolio company and let them spend it. Not saying it's good for founders, but that's why they do it.

gumby• 9 years ago

This should be coming out of the investors' management fee (the 2% of the "2 and 20") but by making "the company" pay they shift the cost onto their LPs.

The best you can do is limit the legal fees in the TS.

SeoxyS2• 9 years ago

Bingo. This is an important detail that's easy to miss; but a VC has a huge incentive to lower its own costs while increasing capital committed. Any expenses come straight from the GPs' pockets. Capital invested is paid for by LPs and the VC even earns management fees on it.

It'd be in a VC's best interest to invest $60k more for the same equity, and make the startup pay that expense, vs. paying for it directly. It's a win-win for startups and VCs. LPs get a bit screwed, however.

anotherfounder16• 9 years ago

So, for founders raising let's say, a seed round (with a Series A 18 months down the line), is the recommendation still raise on SAFE (with some cap and/or discount), and then price it at A?

It would be useful for the founder community (especially outside YC network) to have examples of how different recent startups have done it - offered discount or cap or both, how they determined the cap, the experience at A, experience with SAFE when dealing with angels/micro VCs, etc.

Any founder willing to share that here?

msrpotus• 9 years ago

Very interested in this as well.

dustingetz• 9 years ago

If you don't have concrete plans for a Series A in the 18 month timespan does a SAFE still make sense?

jalonso5102• 9 years ago

That's one place where the SAFE is better than a convertible note - a note will have to have a specific term for maturity, usually 18 or 12 months, but a SAFE can just sit there outstanding indefinitely until an event causes it to convert.

anotherfounder16• 9 years ago

This could get tricky. I imagine, at some point when you feel the round is closing, you'd want to set some terms/valuation and ensure that the biggest investor (or most/all of the investors) feel good about that.

DelaneyM4• 9 years ago

Doing a seed round now.

Ultimately the terms are going to depend on investor consensus, but my strong preference is to go uncapped w/ discount.

Having a cap is an incentive for me to "grow until I'm 6 months away from X, then focus on raising instead". For some seed investors an early valuation & equity conversion may be desirable, but I'd rather "grow until I'm 6 months away from needing funds to (grow faster|survive)".

Having no cap, on the other hand, encourages me to stay lean, grow quickly & ask for money only when it has the greatest value. That's behaviour which may not be friendly to opportunistic short-term VCs looking to get a quick valuation bump, but which is strongly correlated with long-term success and eventual home-runs.

I want to give a discount because seed investors are taking a big risk on me, they deserve it.

anotherfounder16• 9 years ago

This makes a lot of sense, and is also my preferred route. Have you had any feedback or pushback on this route yet?

I am also curious how the reactions differ from Angels to MicroVCs to Seed Funds.

CalChris3• 9 years ago

Having a cap is an incentive for me to "grow until I'm 6 months away from X, then focus on raising instead".

This was my impression as well. I do understand that the deal has to be equitable for both sides. It also has to align interests and as your example shows, the cap doesn't.

The discount obviously makes sense since the seed funder is taking more risk.

lpolovets9• 9 years ago

(I'm a VC)

Uncapped notes are generally a bad idea for everyone involved because they misalign incentives. If you raise a seed at a $6m cap, both your goal and your investors' goal is to help you make as much progress as possible for a Series A. For instance, investors will do whatever they can to help you get to a $30m valuation instead of a $20m valuation. An uncapped note means that investors invest at your next round's price. That means they benefit most of the price of your next round is low. I.e. they'll do as little as possible so that your Series A is at a $20m pre instead of a $30m pre. The misalignment creates perverse incentives. For example, if you ask an investor on an uncapped note to make a key customer intro, if they say yes then their reward if you land the customer is that they'll have even less ownership at the Series A. That's not a good incentive structure :)

ares20124• 9 years ago

No investor will do an uncapped note (unless it's a bridge round) because it's a very bad deal for them. A fixed discount on the round is not enough upside to account for their risk, especially when there are plenty of investments available whether they can get a cap which gives them much more upside.

Investors will do uncapped notes for bridges because there is usually a very short time period between the note and the next round, so they actually make a better return due to the discount than they would in equity appreciation over that short time.

djrogers• 9 years ago

For everyone who had no idea what a safe is (beyond the big metal thing you put valuables in), I eventually found this with some digging:

https://www.ycombinator.com/documents/#safe

AckSyn• 9 years ago

Thanks for sharing this. I had forgotten what it was.

The safe (simple agreement for future equity) is intended to replace convertible notes in most cases, and we think it addresses many of the problems with convertible notes while preserving their flexibility.

stronglikedan• 9 years ago

Curious that it appears to be a non-capitalized acronym. That could definitely cause some confusion.

dang• 9 years ago

The article is written from a place (what Eric Evans calls a 'bounded context') where the term is so well known that people just use it as a common noun. But crossing into the HN context that's no longer true, so we've uppercased it for you above.

(I almost said improper noun but apparently that's like land seahorse.)

ameliaquining• 9 years ago

Apparently YC thought that capitalizing "SAFE" was inconvenient: http://blog.ycombinator.com/announcing-the-safe-a-replacemen...

For what it's worth, I think this causes more confusion than it's worth.

lpolovets9• 9 years ago

This is a good post, but the one thing that stuck out at me is the $60k Series A figure. I have no doubt it's true, but comparing priced Series A legal costs to seed stage SAFE legal costs is apples to oranges. No one is debating using SAFEs for Series A's, as those are already priced rounds ~100% of the time. For a priced seed round, I've heard legal costs can vary from $5k to $20k or so. That's not insignificant, but it's way lower than $60k.

anotherfounder16• 9 years ago

And why is that cost on the founders? Is that true for your investments as well?

sjbase• 9 years ago

Jon's post notes that this is the industry standard. Anecdotal, but my experience matches that claim (last data point being end of 2016).

I've never encountered any compelling rationale as to why/how that standard emerged.

lpolovets9• 9 years ago

I've been a VC for about 5 years and tbh I don't know why this industry standard exists. It's not something that makes sense to me. I think it would be a good change for the industry to get rid of this practice, and I think the change should come from the top (e.g. the National VC Association or from a group of leading VCs).

austenallred• 9 years ago

IMO the largest costs aren't the dollar costs, in fact those barely matter. The large cost to me as a founder are the weeks/months it takes to negotiate a priced round when there's so little data is borderline exercise in futility and so much work that needs to be done by exactly the person that would need to handle those negotiations. But that's more abstract than putting a solid "$60k" number on something.

laser• 9 years ago

Are these supposed founders that haven't done the basic dilution math on the funds they're raising fit to be raising funds at all?

anotherfounder16• 9 years ago

If you are not brought up in the tradition of SV startups, it is far harder than one can imagine. I've worked here and still get confused with the variation in terminology, requirements and preferences. I've a lot of empathy for anyone struggling with figuring this out - this information should be simpler and more accessible.

ryandamm• 9 years ago

The article this is responding to is extremely misleading and is pure clickbait.

Safes are great. They're easy to understand, and any semi quantitative founders should be able to build dilution spreadsheets without the help of a lawyer.

haltingthoughts• 9 years ago

what is a SAFE? How is it different from standard equity/debt?

elmar2• 9 years ago

The SAFE by design contains a full ratchet anti-dilution protection for the investor, if you have raised a loot of money normally by stacking some SAFES on different dates and then raise the next converting round at a low valuation you can find yourself completely diluted.

HelgeSeetzen2• 9 years ago

As somebody who has been on both sides of the investment table, I can confirm that very few founders understand the complexities of convertible notes (SAFE or otherwise). But I think the authors of both the pro and con argument are covering only one of the points. Yes, first time founders often don't intuitively understand the impact of convertible notes on their cap table. But that's not that hard to model. Much harder to understand are the secondary impacts of convertible notes. I have raised, led and participated in dozens of rounds and, frankly, still get caught out by those.

In general, the problem is that most benefits that investors enjoy are properties of their shares rather than the money that they invested. For an equity round this is one and the same. Not so much for convertible notes. A simple example:

An entrepreneur raised a $1M convertible note with a $5M cap. Ignore discount, interest and other factors for now. She then raises a $5M round at a valuation of $20M. That yields a dilution of 20% for the round plus a "hidden" dilution of ~17% for the note conversion (1/6). That's the blurry issue that both authors discuss. But if anything the share rights are even blurrier. Let's say that the equity round came with what is commonly referred to as a 1x liquidation preference (non-participating). So they would get $5M back before other shareholders get anything. Even though I just worded that as matching the money that they put in, it is generally a property of the share class that the investors hold. For example, their $5M might have bought 5M shares at $1/share that each says "redeemable for $1 or convertible to common shares". Our note investors also hold those shares now. But instead holding one per dollar, they now hold four per dollar (since they pay 1/4 the price for such a share). Suddenly, they have effectively a 4x liquidation preference benefit and the company has to return a full $9M before common shareholders/founders see a penny of payout (despite only having $6M in the bank).

Interest rates, pre-round ESOP increases, and many other factors in convertible notes make this problem worse. And it affects just about all aspects of the cap table including voting rights, protective provisions, redemption rights, etc.. Basically, the bigger the gap between the cap and the eventual round, the bigger the privilege the note investors pick up. Not just in economic benefit where you would expect it, but also in power/insurance/protections/etc. where it isn't obvious at all. Nowhere in your term sheet for the note or equity round will it mention 4x liquidation preference. Doing so would cause instant rejection of the deal by even the most inexperienced founder! But that's exactly would is going to happen once all the conversion mechanics are executed. And that can catch even seasoned entrepreneurs off guard (and seasoned investors, including plenty of note holders who never understood that they would get these benefits).

Convertible notes - SAFE or otherwise - have a role to play in venture financing. But they are complex instruments and should be use carefully. Anything else is just a recipe for pain in the long run.

kirsty2• 9 years ago

Safes (and other convertible securities) convert at the cap, assuming the round valuation is higher than the cap. Where there are safes with multiple caps there are a number of methods that the lawyers use so that investors receive the correct number of shares, while solving for your point about the excess liquidation preferences.

The simplest one is that there are multiple sub classes of preferred stock ("shadow series") - eg for a Series A, there are Series A-1, Series A-2 shares that represent each cap. These classes each have their own liquidation preferences matched to the dollars put in originally. The YC-standard safe also contemplates this by referring to "safe preferred shares".

Another option is that the "extra" shares that the converting safeholders receive as a result of the difference between the conversion price and round price are given as common shares (which have no liquidation preference).

anotherfounder16• 9 years ago

Do you foresee YC Safe equivalent of Series A docs? One that standardizes the terms, and reduces the time/price in the process?

HelgeSeetzen2• 9 years ago

Thanks for the response Kristy. You are absolutely correct that there are ways to fix these problems if you have good lawyers (and leverage). But in my experience this rarely happens. Conversely, I see the default conversion into the same new share class all the time (as a result of negotiation leverage or just because nobody involved knows any better). How does that compare to your observations with your obviously much larger portfolio? For example, what percentage of yc companies using SAFE did the pref+common conversion that you described?

Of course the other concern is that you actually have to be cognisant of this issue - or have a lawyer who is - to catch it. Maybe the SAFE could just mandate the pref+common conversion?

SeoxyS2• 9 years ago

What normally happens in a situation like in your example is that the SAFE or note investors would convert their principal into Series A preferred shares and the remainder would be issued as common stock.

So, in your example, for each dollar invested, seed investors would have 1 preferred share with 1x liquidation preference and a price of $1, and 3 shares of common stock.

yesimahuman2• 9 years ago

We did a Safe in our first VC round (and then converted it in a priced round later), and it was an easy, fast way to close. I had to convince our investor to do one because it was their first, and they also had a very positive reaction to it. Deals die because of time and we were able to get the deal done and get back to work. I would definitely do one again and I think the downsides are overblown.

anotherfounder16• 9 years ago

Was the priced one a priced Seed or priced A? And how much later? What had changed by then?

yesimahuman2• 9 years ago

Second one was a priced seed but honestly it was more like a classic Series A. One after that was a larger priced Series A. Second round we put together a board, didn't do that for the Safe round which was intentional on my end (instead we had a great informal meeting cadence)

danieltillett3• 9 years ago

For those of you who are running Aussie startups we don't have any equivalent of the YC SAFE. We are stuck with pricing rounds even at the seed stage which wastes a huge amount of everyone's time.

I actually tried to get some lawyers here in Australia to convert over the YC SAFE agreements to Australian law and I could not find one. Apparently the big blocking point is none of the law firms wanted to take responsibility for the legal liability. This is one area where our "innovation" government could get involved to sort out.

timavr• 9 years ago

Muru-D does SAFE now and we are raising in Australia only with it. Reach out if need Australia specific templates.

hughstephens• 9 years ago

+1. I've participated as an angel in a few AU rounds with SAFEs and SAFE-like instruments rather than priced rounds.

danieltillett3• 9 years ago

Have these been released publically? You don't have a contact in your profile. Could you get in contact with me?

jeremyt2• 9 years ago

SAFEs are not bad for entrepreneurs, they're bad for investors.

I won't make one anymore.

I've done two deals that involved a SAFE, and it's been almost 2 years and the companies are still looking to raise a round. If they do, I'm looking at a 10-20% return.

It's not worth it for the risk.

Indeed, at least convertible notes are debt and can be seen you're in a liquidation. A SAFE doesn't even give you that.

anotherfounder16• 9 years ago

It seems like in cases where the companies aren't able to raise a round, they are probably not going to work out. At that stage, the point seems moot given the SV mantra of this being a 'a game of outliers'.

Also, if there is a liquidation event, then the SAFE should convert, right? And not sure if you act as an angel or represent a fund, would you rather use convertible notes or price?

jeremyt2• 9 years ago

They convert to shares, which are junior to debt.

middleout• 9 years ago

I'm not a fan of YC (I find it elitist, and imo they crowd out the 99.5% of startups that get rejected), but I can't find fault with the SAFE as an instrument.

To the extent that founders suffer too much dilution while raising via a SAFE, it's more likely the case that there was something not working with the business.

Sure, if the founders could have raised a priced equity round from the get-go, they probably should have done that over a SAFE, but more likely the legal expenses would have been too onerous for that to have been an option...

nodesocket• 9 years ago

If you go with SAFEs for a early Angel round (< $1M), how do you distribute equity for the founders, early (first 3-5) employees, advisors?

jkarneges• 9 years ago

For advisors, there's FAST: https://fi.co/FAST

pmarreck• 9 years ago

Is there a good resource (short of getting a finance degree) that would permit me to fully understand this instrument, the problems it solves, and its caveats? (heck, even a youtube video)

jonbarker• 9 years ago

What's news to me out of all of that is that the transaction cost of series A averages 60k. Seems that the market for series A is a highly inefficient market as I know quite a few series A companies who would love to secure an added 60k a year customer in year one after series A, and would probably pay more for a sales person who could find that customer. Quite a gamble doing a transaction whose cost averages the annual contract value of one prized customer for most companies.

ares20124• 9 years ago

While you can argue that SAFEs are roughly equivalent to equity (with the advantage of allowing rolling closes) they are very bad for startup employees. Many startup employees have no idea how much they really own of a company because their equity disclosures do not include the conversion of the SAFEs upon future equity rounds.

I have met many companies where the first few employees think they own 1% of the company, and after a Series A where 25% is sold they find out they only own 0.5% because the SAFE conversions took up another 25%.

In some cases founders don't understand what is happening or how to include SAFEs in their cap table, in other cases they are purposefully obscuring the cap table. Whatever the reason it's very bad.

mrkurt2• 9 years ago

SAFEs (and convertible notes) are also good for pre-equity round employees because companies can grant them shares instead of options. People who own shares outright are much better off tax-wise than people with options.

You are right, though, employees are better off when they understand conversion mechanics. And when they don't work for dillholes that mislead them with complexity.

ares20124• 9 years ago

You can grant employees shares regardless of how you raise outside capital. Whether or not you do so is a decision of the company leadership, not a result of how you raise money.

SAFEs are not bad for entrepreneurs

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