[Note: see here for this piece published in Japanese.]
When I raised money for my startups in the 90s, preferred shares were the primary investment instrument employed by VCs. Convertible notes and venture loans occasionally made an appearance on the debt financing side, especially during the run-up period to the dot-com bubble.
One of today’s most popular financing instruments favored by new entrepreneurs, the SAFE note (Simple Agreement for Future Equity), would not yet be invented for more than a decade.
Given their abundance nowadays, I thought I would share my perspective on SAFE notes as a follow-on VC in companies that have previously issued them, as well as an occasional investor in SAFE notes directly.
SAFE notes sprung out of the convertible note instrument. Y Combinator invented the SAFE note in 2013 as an alternative to convertible notes that is beneficial for both companies and investors. Their goal was admirable: simplifying the agreement into a standardized instrument facilitates certainty and speed, and consequently reduces transaction costs.
The original rationale for a convertible note, even before SAFE notes came along, went something as follows:
At its very earliest stage, placing a valuation on a startup is challenging. Few metrics exist which could underpin any substantial quantitative discussion, thus making it hard for parties to agree. The entrepreneur believed his (yes, it was usually a male) idea was already worth gazillions out of the gate, whereas the investor couldn’t justify settling for equity crumbs in a venture which without funding wouldn’t see the light of day.
So the convertible note broke this stalemate by postponing the valuation event until the next financing round. The initial investor would grant a loan which converts at the future valuation, with a discount (say 30%) for taking on earlier risk.
The convertible note subsequently proved useful in another set of circumstances: when raising a consecutive priced round takes longer than expected and requires existing shareholders to bridge the company to give it more time. The benefit here is similar: only the market can determine the fair valuation of the company, not insiders, so the convertible note does not perturb the process, just extend the runway a bit.
Convertible notes can be tailored to best fit a given situation. SAFE notes, on the other hand, are by design more standard and rigid in their application. I have witnessed how the very benefits of simplicity and expediency can lull entrepreneurs into defaulting to SAFE notes anytime they need to raise money.
One of the most notorious dangers arises when founders raise two or more consecutive rounds of SAFE notes. The benefit of postponing the difficult valuation discussion at the early stage can become detrimental when the priced equity round inevitably comes (if they make it that far). Layering SAFE notes is simply kicking the can down the road.
I have seen founders overlook several important considerations when raising consecutive SAFE notes:
1. Failing to grasp the future dilutive impact. Since SAFE notes do not accompany any immediate dilution until they are converted, some founders fail to model the future dilution impact in their cap tables once all of the outstanding notes convert. One layer of notes is fairly easy to calculate in your head, but two or three layers at different valuation caps and/or discounts can quickly escalate into a more complex set of calculations.
2. Mistaking valuation cap for company valuation. It is tempting for founders to confuse the valuation cap in the SAFE note with the market valuation of the company. This is a mistake. The very rationale for implementing a SAFE note is that valuation parameters were too challenging to quantify. A founder whose startup issued subsequent layers of SAFE notes with valuation caps of 5m, 10m, and 15m respectively may see 15m as the pre-money valuation floor of their company. It is not. The pre-money valuation of their company will only be determined when an outside lead investor prices it, by definition.
3. “Crowding out” future lead investors. Another potential drawback of SAFE notes at later stages is that they may “crowd out” prospective new investors in your company. VC funds may take a pass on investing because the cascading conversion of notes would consume too much equity. Fred Wilson explains this phenomenon far more persuasively than I ever could, so I encourage you to read his blog post about it here.
4. Overlooking the impact on the post-money valuation calculation. SAFE notes create a multiplier effect on the post-money valuation calculation. This multiplier effect is exacerbated by the magnitude of the discrepancy between the valuation cap and the actual valuation from a priced equity round.
5. Ignoring the market. Finally, founders who layer SAFE notes upon SAFE notes may be ignoring an implicit signal from the market: that no sophisticated institutional investor is willing to lead a priced equity round in their company.
In the next piece, I’ll simulate the impact on dilution and post-money valuation of consecutive SAFE notes.
