
SAFEs are not bad for entrepreneurs - janober
https://blog.ycombinator.com/safes-are-not-bad-for-entrepreneurs/
======
anotherfounder
So, for founders raising let's say, a seed round (with a Series A 18 months
down the line), is the recommendation still raise on SAFE (with some cap
and/or discount), and then price it at A?

It would be useful for the founder community (especially outside YC network)
to have examples of how different recent startups have done it - offered
discount or cap or both, how they determined the cap, the experience at A,
experience with SAFE when dealing with angels/micro VCs, etc.

Any founder willing to share that here?

~~~
DelaneyM
Doing a seed round now.

Ultimately the terms are going to depend on investor consensus, but my strong
preference is to go uncapped w/ discount.

Having a cap is an incentive for me to "grow until I'm 6 months away from X,
then focus on raising instead". For some seed investors an early valuation &
equity conversion may be desirable, but I'd rather "grow until I'm 6 months
away from needing funds to (grow faster|survive)".

Having no cap, on the other hand, encourages me to stay lean, grow quickly &
ask for money only when it has the greatest value. That's behaviour which may
not be friendly to opportunistic short-term VCs looking to get a quick
valuation bump, but which is strongly correlated with long-term success and
eventual home-runs.

I want to give a discount because seed investors are taking a big risk on me,
they deserve it.

~~~
lpolovets
(I'm a VC)

Uncapped notes are generally a bad idea for everyone involved because they
misalign incentives. If you raise a seed at a $6m cap, both your goal and your
investors' goal is to help you make as much progress as possible for a Series
A. For instance, investors will do whatever they can to help you get to a $30m
valuation instead of a $20m valuation. An uncapped note means that investors
invest at your _next_ round's price. That means they benefit most of the price
of your next round is low. I.e. they'll do as little as possible so that your
Series A is at a $20m pre instead of a $30m pre. The misalignment creates
perverse incentives. For example, if you ask an investor on an uncapped note
to make a key customer intro, if they say yes then their reward if you land
the customer is that they'll have even less ownership at the Series A. That's
not a good incentive structure :)

~~~
pcmaffey
If an investor would rather own 5% of a $20m company than 3.3% of a $30m
company, and specifically limits a company's growth to achieve that end, then
it's likely someone no founder would want to work with. Make the pie bigger,
no?

The real problem with capped notes is that they serve as a proxy for price. If
you're going to price it, just price it. But if a note had a floor + cap that
served as a min/max range for what everyone felt comfortable with, and then
utilize a discount to do the actual work of allowing for uncertainty in the
valuation, that would be the setup that best encapsulates the spirit of
convertible notes (of course, the devil is always in the details).

~~~
lpolovets
> If an investor would rather own 5% of a $20m company than 3.3% of a $30m
> company

It's not that simple because you're not factoring for time. Yes, both of those
stakes are worth $1m, but the risk levels taken by an investor are different.
For example, would you rather own 5% of Amazon when it was worth $20m, or
0.01% when it's worth $10b? Those are both $1m stakes if you ignore time, but
the latter would've been worth much less than the former.

Here's a concrete example using
[https://angelcalc.com/model](https://angelcalc.com/model)

 _Priced round_

I invest $1m at a $10m post, owning 10%.

\- If your next round is $5m at $20m pre, I'll own 8% (post-dilution) which
will be worth $2m.

\- If your next round is $10m at $40m pre, I'll own 8% which will be worth
$4m.

If your valuation doubles, so does the value of my investment, and I keep an
8% take in either case.

 _Uncapped note_

I invest $1m on an uncapped note, 20% discount.

\- If your next round is $5m at a $20m pre, I own $1.25m (5%).

\- If your next round is $10m at a $40m pre, I own $1.25m (2.5%).

Note that 1) my upside is capped to $1.25m (that's the 20% discount I got) and
2) the better your next round, the lower my ownership.

 _Closing thoughts_

The reason the uncapped note is even more unattractive is that most companies
have some perceived ideal outcome. Let's say it's a max $2b exit for this
specific company. For a priced round, I own 8% of a company that could go up
to $2b in value. For an uncapped note, I own 5% if you raise at a $20m pre, or
2.5% if you raise at a $40m pre. Note that the better you do, the lower my
percentage, and hence the lower my potential upside. If you raise at a $20m
pre my stake might be worth $2b x 5% = $100m someday. If you raise at $40m pre
my stake might be worth $2b x 2.5% = $50m someday. If you really knock it out
of the ball park and raise $20m on an $80m pre for your Series A, my max
upside is $25m. Again, this makes no sense because I invested $1m at the exact
same time in both the priced round and the uncapped note round, but in the
priced round instance I own 8%, while in the uncapped round I probably own
much less, and the better you do on your way to a $2b exit, the worse I do.
That's a strong misalignment and there's no way for me to make that pie
bigger.

~~~
pcmaffey
Thanks Leo for the detail response. The problem with this analysis is that
you're comparing a priced round to an uncapped note, but using totally
different and arbitrary parameters (ie. 20% discount).

I agree 20% discount is not an accurate assessment of the risk and potential
increase in value from seed to A, which is usually 3x. Also, the original
purpose of a note is to solve the problem of inaccurately pricing an early
stage company. If that's not a problem then there's no point in not pricing.
But if there's great variation in the potential of a company, then it makes
sense to use a variable pricing model, which a significant discount (30-60%)
better accounts for. Add in a cap and a floor (something like $4m - $40m) to
protect founder & investor in extreme situations like you described.

Obviously a fixed price is better for you, the investor. But is it better for
the company? Is it the best way to model the uncertainty of valuation? You
argue for not dissentivizing the investor. What about the founder who raises
$1m seed at $5m valuation, then raises Series A at $30m? They mispriced their
seed round, and the likelihood of the A investors finding a way to diminish
the value of the seed investors greatly increases.

Just an alternative view of things from an outside.

~~~
lpolovets
I appreciate the follow up. I think where we disagree is that a priced round
is a disincentive to the founder. Instead of a disincentive, I think a priced
round is "fair." A few quick comments:

\- are there any other areas where, as a buyer/investor, you buy at a discount
to a future price instead of an estimated current price? For example in places
where houses appreciate quickly, people still buy houses at a fixed price. No
seller ever says "this house might be worth $2m-5m in 10 years, so instead of
buying it for $1m today, which don't you buy it for a 20% discount to when you
sell it 10 years from now?" Same thing with paintings, stocks, etc.

\- the $5m -> $30m mark-up is not a mispricing. For public stocks, pricing is
based is based on expected cash flows. For example, if a company is expected
to make $10m/year for 30 years, it might be worth $300m today, minus an
adjustment for inflation (so maybe it's only worth $200m today). For startups,
the valuation is based on "% chance of a huge outcome." So when a company goes
from $5m to $30m in valuation, that doesn't mean its revenues jumped 6x. What
it really means is investors think the company made enough progress so that
instead of a 1% chance at a $1b exit, there's now a 6% chance at a $1b exit.
In that regard, the company is worth $30m today, but it was also not worth
that at the seed round.

------
oyeanuj
> and the industry standard is that companies pay for BOTH their own legal
> counsel and the investor’s legal fees.

Serious question - how is this still the case, or make any sense? Wouldn't it
be in the investor's interest that the company doesn't spend $60K out of their
raise on this, and instead on hires, product, etc?

And given how standard a process this must be for every VC firm, I imagine
they would have a well-negotiated rate, which for them is an incremental cost
of investing?

I'd like to believe that there are firms out there that don't do this, and
that this is turns out to be some sort of advantage for them (a form of
founder-friendly/company-friendly, if you will).

~~~
harryh
_Serious question - how is this still the case, or make any sense? Wouldn 't
it be in the investor's interest that the company doesn't spend $60K out of
their raise on this, and instead on hires, product, etc?_

No, it would not be in the investors best interest to make that change. Under
the current system all of the money spent is used to buy shares in the
company. Under a system where the VC firm was responsible for their own legal
fees then $25k (or whatever) would go directly to the lawyers instead of
buying shares so they would end up with a bit less ownership.

EDIT: To be clear I'm not saying that I am in favor of the status quo. I am
not. I'm just saying that it is understandable given the incentives of VC
firms.

~~~
arohner
The VCs aren't the investors here.

There are 3 parties, the startup, the VCs and the LPs. The LPs are generally
pension funds, college endowments, and sovereign wealth funds, i.e.
institutions who can write $10M-$100M checks. The VCs are their agent, like a
real estate agent helping you buying a house.

While VCs put their own money into the fund, generally the vast majority of
the fund money comes from the LPs. The VCs get paid 2 and 20, 2% of the fund
per year for things like salary and rent, and the first 20% of profits from
the fund when it ends, in 10 years. Because of this structure, they don't get
to treat the fund money as their own personal piggybank.

No matter who pays, the cost of a deal is going to be <money startup receives>
\+ <startup legal costs> \+ <VC legal costs>.

Raising the cost for the VCs, without changing 2 and 20 just results in
increased costs for the VC. Paying their own legal costs means they'll do
fewer deals, with larger check sizes.

~~~
logicallee
you missed the parent's point.

if it paid its own legal fees it would get that much less equity.

imagine I said "I'll invest 1M at a 2M valuation but you have to burn 800K of
it in a bonfire." vs if I said "I'll invest 200K at 2M valuation but I'll
celebrate by burning 800K in a bonfire."

The same thing happens to the money (it burns in a bonfire / goes to the
lawyers) but in the first one I have 50% of your company and in the second one
I have 10% of it.

Because in the first one I added it to the equity investment before making you
pay it.

------
djrogers
For everyone who had no idea what a safe is (beyond the big metal thing you
put valuables in), I eventually found this with some digging:

[https://www.ycombinator.com/documents/#safe](https://www.ycombinator.com/documents/#safe)

~~~
stronglikedan
Curious that it appears to be a _non-capitalized_ acronym. That could
definitely cause some confusion.

~~~
ameliaquining
Apparently YC thought that capitalizing "SAFE" was inconvenient:
[http://blog.ycombinator.com/announcing-the-safe-a-
replacemen...](http://blog.ycombinator.com/announcing-the-safe-a-replacement-
for-convertible-notes/)

For what it's worth, I think this causes more confusion than it's worth.

------
ryandamm
The article this is responding to is extremely misleading and is pure
clickbait.

Safes are great. They're easy to understand, and any semi quantitative
founders should be able to build dilution spreadsheets without the help of a
lawyer.

~~~
haltingthoughts
what is a SAFE? How is it different from standard equity/debt?

------
yesimahuman
We did a Safe in our first VC round (and then converted it in a priced round
later), and it was an easy, fast way to close. I had to convince our investor
to do one because it was their first, and they also had a very positive
reaction to it. Deals die because of time and we were able to get the deal
done and get back to work. I would definitely do one again and I think the
downsides are overblown.

~~~
anotherfounder
Was the priced one a priced Seed or priced A? And how much later? What had
changed by then?

~~~
yesimahuman
Second one was a priced seed but honestly it was more like a classic Series A.
One after that was a larger priced Series A. Second round we put together a
board, didn't do that for the Safe round which was intentional on my end
(instead we had a great informal meeting cadence)

------
lpolovets
This is a good post, but the one thing that stuck out at me is the $60k Series
A figure. I have no doubt it's true, but comparing priced Series A legal costs
to seed stage SAFE legal costs is apples to oranges. No one is debating using
SAFEs for Series A's, as those are already priced rounds ~100% of the time.
For a priced seed round, I've heard legal costs can vary from $5k to $20k or
so. That's not insignificant, but it's way lower than $60k.

~~~
anotherfounder
And why is that cost on the founders? Is that true for your investments as
well?

~~~
lpolovets
I've been a VC for about 5 years and tbh I don't know why this industry
standard exists. It's not something that makes sense to me. I think it would
be a good change for the industry to get rid of this practice, and I think the
change should come from the top (e.g. the National VC Association or from a
group of leading VCs).

~~~
CalChris
Similarly, why do sellers pay closing costs for houses? Makes zero sense. The
money is flowing from the buyer to the seller. It also inflates the price of
the house since the buyer has to pay the seller to pay the closing costs. Then
you have to pay mortgage interest and property tax on that inflated value.

I paid closing costs when I bought, and as my realtor said, it's like free
cable. It's not a massive savings but it's free cable every month.

~~~
terravion
Having the seller pay closing costs essentially allows the buyer (the buyer
always pays transaction costs from an economic perspective) to pay the closing
costs through the mortgage. I.e. the house costs 10% more, but you can
mortgage it, instead of an extra 10% out of pocket.

The rationale, from the VC's perspective for the company paying for a priced
transaction is the same. Really this is a way of making the LPs of the fund
pay for the transaction (i.e. their money given to the company to pay the
transaction) rather than the VC having to pay transaction expenses out of
their fees.

------
ares2012
While you can argue that SAFEs are roughly equivalent to equity (with the
advantage of allowing rolling closes) they are very bad for startup employees.
Many startup employees have no idea how much they really own of a company
because their equity disclosures do not include the conversion of the SAFEs
upon future equity rounds.

I have met many companies where the first few employees think they own 1% of
the company, and after a Series A where 25% is sold they find out they only
own 0.5% because the SAFE conversions took up another 25%.

In some cases founders don't understand what is happening or how to include
SAFEs in their cap table, in other cases they are purposefully obscuring the
cap table. Whatever the reason it's very bad.

~~~
mrkurt
SAFEs (and convertible notes) are also good for pre-equity round employees
because companies can grant them shares instead of options. People who own
shares outright are much better off tax-wise than people with options.

You are right, though, employees are better off when they understand
conversion mechanics. And when they don't work for dillholes that mislead them
with complexity.

~~~
ares2012
You can grant employees shares regardless of how you raise outside capital.
Whether or not you do so is a decision of the company leadership, not a result
of how you raise money.

------
middleout
I'm not a fan of YC (I find it elitist, and imo they crowd out the 99.5% of
startups that get rejected), but I can't find fault with the SAFE as an
instrument.

To the extent that founders suffer too much dilution while raising via a SAFE,
it's more likely the case that there was something not working with the
business.

Sure, if the founders could have raised a priced equity round from the get-go,
they probably should have done that over a SAFE, but more likely the legal
expenses would have been too onerous for that to have been an option...

------
jeremyt
SAFEs are not bad for entrepreneurs, they're bad for investors.

I won't make one anymore.

I've done two deals that involved a SAFE, and it's been almost 2 years and the
companies are still looking to raise a round. If they do, I'm looking at a
10-20% return.

It's not worth it for the risk.

Indeed, at least convertible notes are debt and can be seen you're in a
liquidation. A SAFE doesn't even give you that.

~~~
anotherfounder
It seems like in cases where the companies aren't able to raise a round, they
are probably not going to work out. At that stage, the point seems moot given
the SV mantra of this being a 'a game of outliers'.

Also, if there is a liquidation event, then the SAFE should convert, right?
And not sure if you act as an angel or represent a fund, would you rather use
convertible notes or price?

~~~
jeremyt
They convert to shares, which are junior to debt.

------
elmar
The SAFE by design contains a full ratchet anti-dilution protection for the
investor, if you have raised a loot of money normally by stacking some SAFES
on different dates and then raise the next converting round at a low valuation
you can find yourself completely diluted.

------
danieltillett
For those of you who are running Aussie startups we don't have any equivalent
of the YC SAFE. We are stuck with pricing rounds even at the seed stage which
wastes a huge amount of everyone's time.

I actually tried to get some lawyers here in Australia to convert over the YC
SAFE agreements to Australian law and I could not find one. Apparently the big
blocking point is none of the law firms wanted to take responsibility for the
legal liability. This is one area where our "innovation" government could get
involved to sort out.

~~~
timavr
Muru-D does SAFE now and we are raising in Australia only with it. Reach out
if need Australia specific templates.

~~~
hughstephens
+1. I've participated as an angel in a few AU rounds with SAFEs and SAFE-like
instruments rather than priced rounds.

~~~
danieltillett
Hugh where did these docs come from?

------
pmarreck
Is there a good resource (short of getting a finance degree) that would permit
me to fully understand this instrument, the problems it solves, and its
caveats? (heck, even a youtube video)

------
jonbarker
What's news to me out of all of that is that the transaction cost of series A
averages 60k. Seems that the market for series A is a highly inefficient
market as I know quite a few series A companies who would love to secure an
added 60k a year customer in year one after series A, and would probably pay
more for a sales person who could find that customer. Quite a gamble doing a
transaction whose cost averages the annual contract value of one prized
customer for most companies.

------
thefahim
The cost of priced rounds is often brought up as a reason to choose a SAFE.
Why are priced rounds so expensive in the first place?

~~~
taylorwc
Short answer: attorneys.

When you do a priced round, you have to go in and change many aspects of a
company's legal structure. For example, the documents drafted in a priced
round may include amendments to the charter, a voting agreement, a stock
purchase agreement, a right of first refusal agreement, a shareholder
agreement. Drafting the legal docs for a convertible note or SAFE is less
intensive and time consuming.

~~~
thefahim
Amendments, right of refusal, etc do not happen in SAFE rounds. Why do we
assume they should happen in a priced round? Seems like all these documents
have been generally standardized so the cost should be the same barring
investors asking for extra rights in a Series A.

------
HelgeSeetzen
As somebody who has been on both sides of the investment table, I can confirm
that very few founders understand the complexities of convertible notes (SAFE
or otherwise). But I think the authors of both the pro and con argument are
covering only one of the points. Yes, first time founders often don't
intuitively understand the impact of convertible notes on their cap table. But
that's not that hard to model. Much harder to understand are the secondary
impacts of convertible notes. I have raised, led and participated in dozens of
rounds and, frankly, still get caught out by those.

In general, the problem is that most benefits that investors enjoy are
properties of their shares rather than the money that they invested. For an
equity round this is one and the same. Not so much for convertible notes. A
simple example:

An entrepreneur raised a $1M convertible note with a $5M cap. Ignore discount,
interest and other factors for now. She then raises a $5M round at a valuation
of $20M. That yields a dilution of 20% for the round plus a "hidden" dilution
of ~17% for the note conversion (1/6). That's the blurry issue that both
authors discuss. But if anything the share rights are even blurrier. Let's say
that the equity round came with what is commonly referred to as a 1x
liquidation preference (non-participating). So they would get $5M back before
other shareholders get anything. Even though I just worded that as matching
the money that they put in, it is generally a property of the share class that
the investors hold. For example, their $5M might have bought 5M shares at
$1/share that each says "redeemable for $1 or convertible to common shares".
Our note investors also hold those shares now. But instead holding one per
dollar, they now hold four per dollar (since they pay 1/4 the price for such a
share). Suddenly, they have effectively a 4x liquidation preference benefit
and the company has to return a full $9M before common shareholders/founders
see a penny of payout (despite only having $6M in the bank).

Interest rates, pre-round ESOP increases, and many other factors in
convertible notes make this problem worse. And it affects just about all
aspects of the cap table including voting rights, protective provisions,
redemption rights, etc.. Basically, the bigger the gap between the cap and the
eventual round, the bigger the privilege the note investors pick up. Not just
in economic benefit where you would expect it, but also in
power/insurance/protections/etc. where it isn't obvious at all. Nowhere in
your term sheet for the note or equity round will it mention 4x liquidation
preference. Doing so would cause instant rejection of the deal by even the
most inexperienced founder! But that's exactly would is going to happen once
all the conversion mechanics are executed. And that can catch even seasoned
entrepreneurs off guard (and seasoned investors, including plenty of note
holders who never understood that they would get these benefits).

Convertible notes - SAFE or otherwise - have a role to play in venture
financing. But they are complex instruments and should be use carefully.
Anything else is just a recipe for pain in the long run.

~~~
kirsty
Safes (and other convertible securities) convert at the cap, assuming the
round valuation is higher than the cap. Where there are safes with multiple
caps there are a number of methods that the lawyers use so that investors
receive the correct number of shares, while solving for your point about the
excess liquidation preferences.

The simplest one is that there are multiple sub classes of preferred stock
("shadow series") - eg for a Series A, there are Series A-1, Series A-2 shares
that represent each cap. These classes each have their own liquidation
preferences matched to the dollars put in originally. The YC-standard safe
also contemplates this by referring to "safe preferred shares".

Another option is that the "extra" shares that the converting safeholders
receive as a result of the difference between the conversion price and round
price are given as common shares (which have no liquidation preference).

~~~
anotherfounder
Do you foresee YC Safe equivalent of Series A docs? One that standardizes the
terms, and reduces the time/price in the process?

~~~
CalChris
At Series A, you are talking about a lot more money and a lot more company
history. So VCs have an incentive and the information to price and negotiate
terms. And at that point, it's best to have a good startup lawyer on your side
of the table because the terms will be many. A Safe is like training wheels
for the complexities Series A will bring.

Really, no one has said it, but one of the few remaining competitive
advantages of Silicon Valley is the legal talent available here. While I read
Venture Hacks and Brad Feld as much as anyone, I'll get a good lawyer
when/before I get to A.

Similarly, LLC's can be a simple stepping stone to Delaware C. Also,
provisional patents are a stepping stone to a full application. Along with
Safes, these allow people to move forward without the complexity and cost of
completeness.

~~~
logicallee
>one of the few remaining competitive advantages of Silicon Valley

few->many

------
nodesocket
If you go with SAFEs for a early Angel round (< $1M), how do you distribute
equity for the founders, early (first 3-5) employees, advisors?

~~~
jkarneges
For advisors, there's FAST: [https://fi.co/FAST](https://fi.co/FAST)

------
laser
Are these supposed founders that haven't done the basic dilution math on the
funds they're raising fit to be raising funds at all?

~~~
anotherfounder
If you are not brought up in the tradition of SV startups, it is far harder
than one can imagine. I've worked here and still get confused with the
variation in terminology, requirements and preferences. I've a lot of empathy
for anyone struggling with figuring this out - this information should be
simpler and more accessible.

------
bmh_ca
> The safe and its predecessor, the convertible note, have almost identical
> conversion features

A SAFE _is_ a convertible note, with standardized language.

~~~
kirsty
Safes and convertible note are both types of Convertible Securities. Ie they
each convert into shares at a future date, usually at a priced round.

A convertible note is structured as debt - there is interest earned until it
converts and a maturity date. There are also terms about repaying the debt.

A safe is not debt - it does not have a maturity date and interest does not
accrue.

So referring to a "Safe Note" is non-sensical because there is no such thing.

~~~
bmh_ca
> The safe is just a convertible note with the "event of default," interest,
> and maturity date provisions stripped out.

> \- Carolynn Levy (inventor of the SAFE)

 _edit_ ... You could argue it's no longer a convertible note with those
provisions taken out, but I'm not sure how much mileage you'd get with that
argument.

~~~
mrkurt
It's no longer a "note" when it loses the debt provisions.

~~~
bmh_ca
> It's no longer a "note" when it loses the debt provisions.

You may be right, but what makes you think that?

The common law and some statutory definitions require only that promissory
note be, upon breach, reducible to what are called "liquid damages" i.e. "a
sum certain in money". This does not mean monetary debt or future payment of
money with or without interest. It just means reducible to a certain amount.

The purpose of having a promise with "a sum certain in money" is on the
enforcement end. The monetary compensation upon breach (damages) of a
promissory note can be unambiguously calculated by a registrar (as opposed to
assessment open to interpretation by a judge). This expedites processes such
as obtaining summary or default judgment.

However, the promise needn't be in money itself, as long as there is an
unambiguous objective calculation of the amount of damages.

I'm not sure how it would be calculable in the case of a note without debt or
interest; I'd need to read the note language. If there was nothing specific,
one could argue it is portion of the pre-money to the the valuation cap, but
that'd be a very loose guess.

