Is SAFE Really That Safe? Part II
The first part of this post discussed the differences between SAFE, CLA and preferred equity financing. This second part will go into some typical use cases and an example, hopefully illustrating the pros and cons of using SAFE.
Use case I: seed funding for an unfunded startup This is what SAFE was intended for - a new startup in need of cash to start operating. SAFE allows such a startup to take any investment amount offered through a standardized agreement (i.e. no legal costs), setting almost no precedents that might become issues in future funding. It also lets the company raise more money whenever offered, simply by issuing additional SAFEs. So what’s the downside? Without any previous investment agreements, relations between the company and investors as well as basic governance are left undefined; things like board structure, reporting and reverse vesting. This may not seem like a problem to many founders since it allows them to do pretty much anything, but experience shows that well governed companies do better. And as time goes by, disagreements between founders and investors are likely to arise. Lack of a reverse vesting mechanism, for instance, could make things very difficult if a founder leaves the company. A solution would be to consult the company’s lawyer (=legal costs), voluntarily define mechanisms like reverse vesting (this can be done through a founders’ agreement), and appoint an external board member (e.g. one of the investors or an industry expert).
Use case II: post seed round bridge In this case, the company should (hopefully) have basic governance, so the drawbacks of the SAFE are less of an issue. Since existing investors usually provide at least some of the bridge, previous investment agreements should give them a say on important things. New investors, however, will be in a different position. The simple solution here is to give new investors some rights that existing investors have, like information rights. In case of a new investor(s) investing a significant amount, consider offering him a board observer.
An Example Y Combinator give a few examples of SAFE conversion. Thing is, they forget to illustrate what happens if things take a downturn. Let’s try to illustrate this through an example: • Investor has purchased a safe for $2,000,000. The Valuation Cap is $10,000,000 and the Discount Rate is 80%. • Due to company performance of a market downturn (remember 2008?), the company must raise money at a lower valuation than originally expected. It negotiates with investors to sell $2,000,000 worth of Series A Preferred Stock at a $4,000,000 pre-money valuation. • Post round, new investors and SAFE holders together will hold over 60% (!) of the company leaving very little to the founders. • The new investors are likely to feel that 30% is not enough to incentivize the founders, and insist that they have a more significant equity position. But additional ESOP allocation to founders would not help since it would not dilute the SAFE holders.
The only solution would be to negotiate with SAFE holders, explaining that they need to agree to dilution in order to save the company. But while equity agreements have things like lead investor and bring along, SAFE, being simple, does not, meaning that consent of all SAFE holders is required. This could be very difficult to achieve. The founders could also outsmart SAFE holders by doing a very small round at, say, $12M pre, converting the SAFE at the cap valuation, and then doing a downround. According to the SAFE this should be possible as there is no qualified round minimum. But since some SAFE holders would probably feel that they were not treated fairly, they might take legal action. A startups is not likely to survive in such a scenario.
I will end with some points on making the SAFE safer for startups and investors alike. As aforesaid, don’t try this at home before consulting your trusted lawyers. • Time: SAFE (and CLA) is meant for bridge funding. It is not a good replacement for an equity round, as your personal credit card or bank overdraft are not good substitutes for a mortgage. Having a plan to raise a round and convert in 6-12 months is a good start. In the longer term, the advantages of simplicity may become big disadvantages, as differences of opinion and expectations between investors and founders start to surface. If a round is not in sight after a year, talk to the SAFE holders and agree on terms for an equity round. • Cap table transparency: SAFE, and especially multiple SAFEs with different cap valuations, make the cap table much less transparent. Make sure to maintain a couple of cap table versions for more and less optimistic conversion scenarios, and review them carefully before issuing another SAFE of ESOP. Don’t forget to account for allocated/promised ESOP plus 10-15% unallocated ESOP post-round. • SAFE Size: while there is no qualified round minimum, the SAFE amount should be small relative to the round size for two reasons. A technical reason is that the round investors will want to have majority of their share class (there are solutions). The real reason is that the next round valuation is highly linked to the round size, and in case of a small round conversion of a large SAFE could result in very high dilution. • Bring-along: in case of multiple SAFE holders, bring-along would allow founders to negotiate with the main investors, knowing that the rest will have to comply. • Next round valuation: when talking to investors about the next round, it’s best to discuss company valuation that includes the equity allocated to SAFE holders, as well as ESOP allocation. The new investors don’t really care whether the previous investment was equity or SAFE, and are only interested in the holding a certain investment amount will buy them. • Investor relations: maintaining good communication with SAFE investors (and all your investors for that matter) is extremely important. Yes, the SAFE gives investors very little say, but a dispute with even one investor before the SAFE is converted could create a lot of trouble. • Don’t become addicted: again, SAFE (and CLA) are tools for interim financing. Issuing multiple SAFEs over a long time might seem easy and simple, just like getting another credit card, but may do a lot of harm in the long term. • Israeli angle: in case of a dispute, having a new and innovative contract means that there is no legal precedent, at least in Israel. The judge deciding on your dispute did not participate in an accelerator or raise seed funding, and his interpretation of what the SAFE is may not be too entrepreneur friendly. Regardless of what Y Combinator’s SAFE Primer document says, a court might rule that what walks like debt, quacks like debt and looks like debt, must be debt.