Founders Issue #69: When SAFEs Are Not Safe

What's Below in Issue #69:

📰 - A look into why VCs don't think SAFEs are safe

📊 - Data behind fewer employees leaving startups, but more being laid off

🎙️- Podcast w/ Sherry Jiang

💵- Premium startup resources

🆓- Free startup resources

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When SAFEs Are Not Safe

Are you a SAFE kind of person or a safe kind of person? Most VCs are the safe type, not the SAFE type anymore.

If you haven’t caught on, I’m referring to the Simple Agreement for Future Equity (SAFE). For about a decade, this tool has become one of the most popular for startup fundraising. However, the recent startup market has most VCs turning their backs on the practice in favor of a more “safe” option - priced rounds or convertible notes.

The SAFE was developed in 2013 by YCombinator as a simple way for early-stage founders to raise money without needing to settle on a price or pay lawyers to negotiate complex terms. For early-stage fundraising, this is perfect since it is fast and efficient and usually allows the founder to raise enough money to bridge them to a more robust Series A round. The SAFE agreement is a simple template with only a few sections that need to be agreed to:

  1. Discount for the investor on the next round’s valuation (usually 20%)
  2. Valuation cap (protect the investor against founders who raise the next round at much higher valuations than expected)
  3. Financing threshold (automatically converts the SAFE to equity when a certain amount is raised)
  4. “Most Favoured Nation” clause to adjust the SAFE to mirror more favorable terms in future SAFEs.

While the agreement is super straightforward, it is also what makes it difficult for investors to invest in.

The Advantages

As implied by the name, the SAFE is usually quite safe. Most of the time, there are no problems and it saves the investors and founders hours of negotiations and legal fees for amounts of money that don’t truly warrant the time or monetary commitment of a priced round. Since there are only 4 items that need to be negotiated (and valuation is NOT one of them), it doesn’t require lawyers to negotiate details involved with valued rounds. Additionally, the simplicity makes it the best vehicle for friends and family who trust the founder, and want to support the startup, but are not able to work through the details of a priced round negotiation. 

The Problems

With simplicity, you lose nuance. While it may seem that the investor has purchased some part of the company, in reality, there was never any transfer of ownership. The SAFE agreement allows an investor to purchase part of the company at the time of the price round for a large discount by giving the money today. Think about it as buying 10 bowling passes in advance for a 20% discount. Giving the money upfront just gives you the right to a discount - the actual transfer of company ownership happens at a priced round (with lawyers).

It is this aspect that creates problems for VCs. Some of the challenges they face are:

  • Lack of control: Unlike priced rounds or convertible notes, SAFE investors do not have any voting rights, board seats, or other forms of influence over the company. They are essentially passive investors who have to trust the founder to make the right decisions for the company.
  • Uncertainty of valuation: Since SAFE does not set a valuation for the company, the investor does not know how much of the company they will own in the future. The valuation cap is only a protection against extreme scenarios, but it does not guarantee a fair valuation. The investor may end up paying too much or too little for the company, depending on how the market values it at the time of the price round.
  • Dilution risk: The SAFE does not have any anti-dilution provisions, which means that the investor may see their ownership stake diluted by subsequent rounds of fundraising. The founder may raise more money using SAFEs or other instruments, and the investor will have no say in the terms or the amount of the new capital. The investor may end up owning a smaller percentage of the company than they expected, or even lose their investment entirely if the company fails to raise a priced round.
  • Added Complexities: the basic SAFE is simple. However, many investors have been adding side letters and adding extra terms as protection in the SAFE contract. This creates extra complexities since it becomes similar to a priced round without the pricing or the lawyers. Often founders are not fully aware of the ramifications that the extra terms will have since the SAFE is intended to be closed without legal help. In this situation, it is probably better for a founder to get a lawyer or perhaps just make it a priced round.
  • No Expiration Date: the SAFE just lingers on your desk until there is a moment to convert it. If the startup never has a priced round or exit, then the investor will never receive their shares. Period. Some SAFES have tried adding terms to avoid this problem, but as we stated, that only creates complex problems since it forces the founder and SAFE investor to hire lawyers for the conversion, which would have been easier and cheaper to do at the actual time of investment. 

The Future 

Despite these drawbacks, the SAFE is not going away anytime soon. In 2022 online startup investing (Reg CF and Reg A+), 414 out of 1308 equity deals were SAFEs - roughly 32%. It is still a useful tool for early-stage founders who need to raise money quickly and efficiently, without getting bogged down by valuation discussions or legal complexities. It is also a good option for investors who are willing to take a higher risk for a higher reward, and who believe in the founder’s vision and potential. The SAFE may not be the safest option, but it is certainly the simplest one.

However, we have seen a push by investors towards “safer” options for them - mainly convertible notes. 

The convertible note is a hybrid between debt and equity, where the investor lends money to the company and receives the right to convert it into equity at a later date, usually at a discount or a cap. This gives the investor some protection and leverage over their investment, and the founder some flexibility and speed for their fundraising. However, this also creates some complexity and uncertainty for both parties, as the conversion terms may vary depending on the outcome of the next round.

The major advantage for investors using convertible notes is that they have legal recourse to get control of their money. It is a regular debt that (almost always) is converted to equity at the next priced round (similar to SAFEs). However, if the company never takes another funding round, the investor is still owed their money as debt.

As a founder, there are many ways to raise capital at the early stage without paying for expensive lawyers. However, you should be aware of the dangers and what the VCs are fearful of. Don’t be surprised if they want to add extra terms or push for convertible notes. If you are unsure how it will impact your company in the future - always ask a lawyer. 

Relevant Articles for SAFEs

  • The Problem With SAFEs In Venture Capital - 👉 The VC Factory
  • Demystifying SAFEs: The good, the bad, and the ugly - 👉 DLA Piper
  • The Great Debate – Are SAFEs Actually Bad for Investors? - 👉 Crowd Wise

-------------------------------------------------------------------------------------------------------------------------------------------------------------Data Corner

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Fewer people leaving startups, but most are no longer by choice

For the first time in almost a year, more people are being laid off within startups than leaving by choice. While it is a bleak sign of startups closing down more rapidly, the total number of people leaving has been decreasing as well. We are expecting that the number of layoffs will continue to climb as the fundraising market is still very tight. However, the good news is that retention is doing better with fewer employees leaving overall. 

-------------------------------------------------------------------------------------------------------------------------------------------------------------Fundraising Demystified Episode #37 is Live! Ex-Googler Shares Her Secrets to Pivoting After Raising $3M

EP 37 Sherry Jiang YT Thumbnail

Sherry Jiang Shares Her Secrets to Managing Her Burn and Repitching Existing Investors After a Major Pivot.

In this episode, I talked with Sherry Jiang, co-founder and CEO of Peek. Money, formally known as Blue Jay Finance, where she shares her journey from leaving Google to starting her own company. Blue Jay Finance aims to solve the problem of managing personal finances by providing an intelligent net worth tracker and personalized insights.

Sherry explains her decision to take a bold bet on Asia and build her company in Singapore. She first jumped into fintech focusing on stablecoins, even with the ups and downs of the crypto market. When COVID hit, raising money got tough. But Sherry got creative and focused on small checks to get intros to bigger checks. Sherry didn't just look for money; she also worked on making real connections beyond the context of fundraising.

Amidst pivots in the company's direction and changes in co-founder dynamics, she stayed focused on being careful with money and keeping things simple. She made sure they didn't spend too much and always looked for ways to make revenue. She offers tips for founders dealing with pivots, focusing on key metrics, communicating effectively, and having a nuanced perspective on the process.

Listen Here

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