
Convertible and SAFE notes - ikeboy
http://avc.com/2017/03/convertible-and-safe-notes/
======
paul
It's really not that hard to understand how these notes convert and how much
you are diluting if you spend just a few minutes modeling it out with
[https://angelcalc.com](https://angelcalc.com)

Of course it's still possible to get more dilution than expected if you raise
at unrealistically high caps (or uncapped!) and convert at a lower valuation
down the road, but even that is probably less painful than a conventional down
round.

~~~
ravibala1
Agreed. We walked all our angels through a 3 scenario (low, goal, home-run)
Series A pre-money valuation analysis using a calculator. Bit overwhelming for
some but everyone appreciated the effort.

The biggest benefits of the note structure to us were a) Rolling close b) Not
wasting time debating "valuation" when neither us nor the angels were capable
of estimating a number with limited to no data.

~~~
jon_richards
How does a safe prevent you from debating valuation? It seems like a safe note
with no discount is rarely a good deal unless you hit the valuation cap (why
not just wait until A otherwise?), and if you do hit the cap it's essentially
equivalent to investing in a round priced at the cap (a little worse due to
preference caps).

In what way is the cap not a "valuation"?

~~~
dankohn1
The argument for a seed investor to invest in a SAFE note with no discount and
no cap is that the Series A round will be priced by a VC or superangel, and
the seed investor will not otherwise have the opportunity to invest at that
later point. That is, the seed investor is trading the opportunity to
participate in an investment at all for control over the exact terms. But
since neither the entrepreneur nor the seed investor have any idea what a pre-
revenue company is worth, they're often fine delaying the valuation question.

------
rdl
This isn't as epic as the "extended option exercise periods screw employees!
Really!" post from Scott Kupor of a16z ([http://a16z.com/2016/06/23/options-
timing/](http://a16z.com/2016/06/23/options-timing/)), but close. FFS.

The "bad case" alternative to the second/third round of notes is often a down
round or running out of money -- way worse.

The "good case" alternative of a second higher cap note batch is fine.

Founders and early investors can get screwed even if they raised as equity
early on, too.

~~~
rdl
(Er, sorry, didn't mean to be this mean; I'd been stuck in flight delays for
hours.)

I do think the analysis is both incorrect in conclusion (SAFE _is_ the best
choice in many/most cases for both sophisticated founders and new founders),
and the case badly supported in the blog post.

But it probably isn't someone doing the equivalent of pushing a self-serving
agenda, which was my instinctive reaction and thus defensiveness.

------
lpolovets
(I'm a seed-stage VC, but as a caveat I'm not an expert when it comes to cap
tables.)

He's an example of where having many notes can hurt founders:

\- Raise $2m at an $8m cap, 15% discount.

\- Raise $2m at an $18m cap, 15% discount.

\- Raise $2m at a $28m cap, 15% discount.

\- Sell 20% of company for $X in the Series A.

Caps are "sort of" like pre-money valuations, so the founder might expect that
their dilution from the 3 notes is approximately 2/10 + 2/20 + 2/30 = 36.7%

Here's what actually happens in 4 different scenarios:

1) Raise $10m at a $40m pre. Dilution from the notes is 20.0 + 8.9 + 5.7 =
34.6%

2) Raise $7.5m at a $30m pre. Dilution from the notes is 20.0 + 8.9 + 6.3 =
35.2%

3) Raise $5.0m at a $20m pre. Dilution from the notes is 20.0 + 9.4 + 9.4 =
38.8%

4) Raise $4.0m at a $16m pre. Dilution from the notes is 20.0 + 11.8 + 11.8 =
43.6%

For the founder, #1 and #2 are better than expected, #3 and #4 are worse. It's
not hard to get into situation #3 or #4 if you raise money from strategic
investors or angels at high caps, and then Series A investors drive your price
down below your most recent caps because that's where the market is. The 9%
dilution difference between the first and last scenarios is fairly dramatic.
When you combine that with the 20% dilution from the Series A, it's the
difference between founders and employees having ~45% of the company vs ~36%
of the company.

(Source of calculations: [https://captable.io/company/8/convertible-
notes/calculator](https://captable.io/company/8/convertible-notes/calculator))

~~~
genericpseudo
Isn't that functionally just a down round?

~~~
lpolovets
Yes. But based on my understanding of conversion mechanics, the anti-dilution
terms in priced seed rounds are often "weighted average" (which are more
founder friendly) while in SAFEs and notes they are closer to "full ratchet"
(which are founder unfriendly). An example of the two types of anti-dilution
provisions is worked out at
[https://www.strictlybusinesslawblog.com/2014/03/08/venture-c...](https://www.strictlybusinesslawblog.com/2014/03/08/venture-
capital-term-sheet-negotiation-part-7-anti-dilution-provisions/)

------
kirillzubovsky
It's great when a VC makes a pro-VC argument and without any hard data cites
feelings as the reason why founders should do what he says. AVC has some great
ideas, but sometimes it's pure propaganda.

If you're just raising a small seed in order to get something going, what's
more important than moving fast and getting the product to market?

~~~
fredwilson
This is not a pro VC argument. You may want to believe that. But that's not
what I'm trying to say

------
mrkurt
I'm ambivalent about notes vs priced rounds for founders. I agree that they
create nasty surprises at conversion time.

But notes/SAFEs are great for the earliest employees since we can grant them
real shares instead of options. Plus, we can do it at par value.

Shares granted before a priced round are typically identical to the shares a
founder has, with all the same tax advantages.

Doing priced rounds early means having to worry about a 409a early, and
probably giving employees worse quality equity (or creating income tax
problems for them).

~~~
DenisM
Huh? Surely you cannot do 83b election for the employees who joined after 30
days since the company formation?

And if you don't, that makes situation a lot worse for the employees, as they
end up owning taxes at each vesting event.

~~~
zamfi
83b doesn't have that restriction. You just have to file within 30 days of
receiving the shares. Can be indefinitely long after company formation, since
it's an election made by the employee, not the company.

------
pbiggar
I really really dislike when VCs make a pro-investor claim and try to hide it
in founder-friendly terms.

Priced rounds are great for VCs because they remove all their risk. But they
don't remove any founder risk. Do a down-round after a priced round and you'll
wish you were just taking more dilution from a SAFE.

> "1\. They defer the issue of dilution until a later date".

When the company is doing well, notes allow founders get less dilution,
sometimes way less. This is great for founders, and is just about the only
time in the whole startup thing where things go better than expected for
founders.

If the company is doing badly, I'll take a lower conversion rate over having
to raise a down-round any day.

> "2\. They obfuscate the amount of dilution the founder(s) is taking. I think
> many investors actually like this"

He sets up a moral imperative: you're an irresponsible founder if you don't
know what dilution you're taking. But I know what dilution I'm taking: it's X
_or less_!! (Again, in a down-round I'm fucked either way, so the downside of
notes doesn't matter)

> "3\. I cannot tell you how many angry pissed off angel investors [..] they
> own a LOT less than they thought they did."

And here we get to the crux of the issue, investors own less. If investors own
less, who owns more? Founders do.

> "4\. Most importantly, we cannot and should not continue to allow founders
> to issue notes to investors and not understand how much dilution they are
> taking on each time they do it. This is WRONG."

"Silly inexperienced founders accidentally give investors a bad deal. This is
morally WRONG". Needless to say, I'm unsympathetic to this view.

Look I understand why VCs don't like notes. But to pretend that this is a
founder-friendly thing is beyond irritating (note: he's far from the only VC
to do this!). And this is one of the reasons I trust YC far more than any
other investors - they're in it to help people make startups and they argue
for founder-friendly terms.

(PS there is a real issue in that inexperienced founders might raise too much
thinking its free money, and then they get a lower cap than expected. But my
only bad experience with raising with notes is that VCs treat it as a lower
implied valuation when raising the next round.)

~~~
fredwilson
I wrote this from the heart. You can ascribe whatever agenda you want to
believe. But I wrote this for founders and it is based on thirty plus years of
working with founders. I don't want to see them get screwed and notes screw
them over a lot

~~~
pbiggar
Thanks for saying that!

I don't have any agenda or ascribe any to you. All I think is that to the
untrained eye, this post comes across as founder-unfriendly.

------
platosrepublic
This totally misses how painful it is for a first-time founder to negotiate
against an experienced VC. The power of the SAFE note is that you don't need
to worry about the terms, you know it's acceptable. If there are twenty
different possible funding mechanisms and you have to negotiate which one you
want, the power goes to the VC. Just use a SAFE note.

------
ghshephard
This bit of (excellent) guidance is actually two somewhat separate
suggestions:

 _" Founders should insist that their lawyers publish, to them and the
angel/seed investors, a “pro-forma” cap table at the closing of the note that
shows how much of the company each of them would own if the note converted
immediately at different prices. This “pro-forma” cap table should be updated
each and every time another note is isssued. Most importantly, we cannot and
should not continue to allow founders to issue notes to investors and not
understand how much dilution they are taking on each time they do it."_

Requiring that a cap-table be published is somewhat different than ensuring
that the founders understand their dilution. It's quite likely there is a ton
of overwhelming information/events going on during a close, and it's easy
(though it shouldn't be) at this stage for a founders eyes to glaze over yet
another-table. But taking the extra 60 minutes to walk through the
implications of dilution, and ensuring that they actually _get it_ is
something a responsible investor/VC will do.

------
scott00
I'm not seeing what is confusing about dilution, or how that is exacerbated by
multiple note rounds. Can anybody give an example along with the correct and
incorrect interpretations of terms investors are prone to?

~~~
dmritard96
"or how that is exacerbated by multiple note rounds" \- YES - I too am looking
for a clear and concise example of this. The only people that have ever
suggested this to us were....VCs and from my reading and rereading of all of
our notes, its very unclear as to why this would be some sort of actual
surprise/issue.

------
DelaneyM
This article assumes naive founders and doesn't mention the many situations
wherein convertible notes and (especially) SAFEs are very advantageous to the
founders.

I wonder which situation is more common?

~~~
jacquesm
It's even funnier: SAFE notes are _very_ advantageous to naive founders as
well...

------
dustingetz
This is super light on concrete info, can we have some examples of this house
of cards? and of angels getting screwed?

------
Animats
Maybe these endless rounds of financing even when the company is selling
product aren't such a good idea. The result is often a chicken run for the
bankruptcy cliff. Can you buy dominant market share before the investment
money runs out?

Looking at you, Uber.

------
3pt14159
> They defer the issue of valuation and, more importantly, dilution

That's what the cap if for. If the founder is 19 years old, fine, read a book
on it (I recommend this: [https://www.amazon.com/Funded-Entrepreneurs-Guide-
Raising-Fi...](https://www.amazon.com/Funded-Entrepreneurs-Guide-Raising-
First/dp/1491940263) but basically any will do) but angel investors that don't
know what caps are are dumb angels.

> They obfuscate the amount of dilution the founder(s) is taking.

Also what a cap is for. Unless we're talking about it from the founders
perspective, in which case it's their decision to raise another round or not.
If the dilution doesn't make sense don't raise the round. If you're desperate
and were banking on hitting the cap maybe the company wasn't worth what you
thought it was worth when you raised your Angel round.

> They can build up, like a house of cards, on top of each other

Here I 100% agree. Early family and friends money or angel investments or
small seeds should be convertible, but subsequent rounds should be priced, or
a down round is going to eviscerate the cap table.

> They put the founder in the difficult position of promising an amount of
> ownership to an angel/seed investor that they cannot actually deliver down
> the round when the notes convert.

What? How? Only if the founder is lying or doesn't put in a cap can I possibly
see this happening.

> The company has been around for a few years and has financed itself along
> with way with all sorts of various notes at various caps (or no cap) and
> finally the whole fucking mess is resolved and nobody owns anywhere near as
> much as they had thought.

False dilemma. The choice isn't "use convertible and get a fucking mess" or
"do priced rounds for equity and keep things clean". If you keep your capped
convertible round simple and follow it with a priced round for normal equity
anyone with two brain cells can figure out what the outcome will be given
different scenarios. I've seen some really, really fucked up priced rounds
because some dumb angel investor took a dump on the shareholder agreement and
it took hundreds of thousands in legal fees and payoffs to fix by the time
they were going for what they ended up calling their seed (they renamed their
small seed their angel round).

> It can easily be done for less than $5k in a few days and we do that quite
> often.

That isn't the issue. The issue is that a bunch of regulatory issues come in
once a company is selling stock that a two person startup doesn't want to
waste time dealing with.

> The first convertible or SAFE note issued in a company should have a cap on
> the total amount of notes than can be issued. A number like $1mm or max $2mm
> sounds right to me.

What? Is this at the idea phase or something further along? Because I don't
know anyone that has a $1M cap if there is any serious amount of work or team.

> Don’t do multiple rounds of notes with multiple caps. It always ends badly
> for everyone, including the founder.

I agree. Only do this if you're desperate or if you raised a tiny angel round
(<5% after cap).

> [...] a “pro-forma” cap table at the closing of the note

I agree, though more as a CYA thing to keep relationships good than something
I think would be necessary if the founder set up a sane round in the first
place.

I'm personally not a fan of SAFEs because they can get hairy when you have
lots of angel investors, but convertible is great.

As a partial aside, this whole "strong views weakly held" (see
[http://avc.com/2016/06/strong-views-weakly-
held/](http://avc.com/2016/06/strong-views-weakly-held/) for more details) is
kinda annoying to debate with because it frequently boils down to me having to
colour in the nuance. It's like a less extreme version of arguing with Trump
supporters.

My style is:

Strong views strongly held, until they're no longer strong views because
they've been eroded away by building, credible counter-arguments. I generally
stop talking about the view during this period or when I do talk about it I'll
ask questions. I think of this as weak views weakly held. Then I re-
investigate the view's premises and:

1\. If finding my original assessment still broadly correct, I evaulate the
counter evidence and modify the view to include a greater degree of depth,
since I now understand a further degree of the complexities. The view then
becomes a "nuance aware-strong view, strongly held".

2\. If finding my original assessment false, build a new strong view (strongly
held) from the premises of others.

Strong support carries information "this information should be trusted" and I
don't like broadcasting that signal if my view is weakly held.

~~~
beambot
> The first convertible or SAFE note issued in a company should have a cap on
> the total amount of notes than can be issued. A number like $1mm or max $2mm
> sounds right to me.

By "cap" in this context, I believe he's referring to the aggregate amount of
convertible notes.

~~~
3pt14159
Ah, nice catch. In that case I generally agree with him.

