May 23, 2017

For Angels, Convertible Notes Beat SAFEs


For Angels, Convertible Notes Beat SAFE

Since accelerator Y Combinator introduced the SAFE, or structured agreement for future equity, in late 2013, they have become a popular instrument for pre-seed stage deals, particularly on the West Coast. While some investors love the innovation, I’m with New York angel David Rose in his lack of enthusiasm for the new instrument. Angel investors give up too much by replacing their convertible note with SAFEs.

SAFEs are short, simple, documents that outline investors’ right to purchase equity in a start-up in the future at to-be-determined valuation. In many dimensions, SAFEs are similar to convertible notes. Both instruments allow founders and investors to put off setting company valuation until a future date. And both documents allow earlier investors to receive discounts and for a cap to be imposed on the future valuation. But there are several important differences between convertible notes and SAFEs, which make the former a better choice for most angels.

Why Convertible Notes Beat SAFE

First, and most importantly, SAFEs have no maturity date. That can pose a big problem for angel investors who put money into a company that goes sideways. Without a maturity date, there is no mechanism to require the start-up to repay the investor (or to even encourage the founders to talk to their investor about the issue) or to force the founders to convert the investors’ money to equity. With a SAFE, the founder can keep the investors’ money in limbo forever.

Second, it’s not just the sideways-moving companies where there could be a problem for investors. With a SAFE, a start-up that does well and never has to raise money by selling preferred stock has the opportunity to screw over SAFE investors by issuing dividends only to common shareholders.

Third, with a SAFE, the fiduciary responsibilities of the founder-managers are ambiguous. A SAFE holder receives neither debt nor equity. Therefore, he or she isn’t protected by the fiduciary duty of the management to act in the interests of shareholders, nor by the protections legally afforded to debt holders.

Bill Carleton, a Seattle lawyer who does a lot of early stage legal work, points out that “every contract has an implied covenant of good faith and fair dealing. So arguably there is at least an implicit promise that the company will either raise money, sell or go out of business — all events that trigger something under a SAFE. But there is ambiguity here, and courts have yet to weigh in.”

Fourth, SAFEs are not easy to modify. This inflexibility may protect early stage investors under some circumstances. But it also makes the instrument work poorly in later investment rounds; for companies that don’t raise multiple rounds of capital; for bridge loans; and for follow on rounds.

Fifth, with a SAFE, the investor is getting fewer shares than with a convertible note. A SAFE has no interest rate. Therefore, when the SAFE converts there are no additional shares that come from accrued interest. If the interest rate on a note is 8 to 10 percent, that’s a non-trivial number of shares that the investor is giving up with the SAFE.

Sixth, SAFEs are a California financing innovation. That makes it harder to use elsewhere. Investors on the East Coast and in the Midwest rarely use them. That rarity can pose problems for fundraising efforts by lead investors and founders. It is difficult enough to raise money for an uncertain start-up when the investors are perfectly comfortable with the financial instrument being used. But add in a novel instrument and it may prove nearly impossible to persuade investors to come on board.

Vintage Car Photo via Shutterstock

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Scott Shane


Scott Shane Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of nine books, including Fool's Gold: The Truth Behind Angel Investing in America ; Illusions of Entrepreneurship: and The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By.

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