1. YC has once again managed to innovate in fascinating ways that help promote startups. And, it should be said, the legal work behind formulating this instrument called a "safe" is both sophisticated and commendable. It is at once simple and subtle and it covers a lot of nuanced legal technicalities that must have required some pretty careful thought to get right. The result should be extremely helpful to startups and their founders and gives founders one more powerful tool to use for their most important funding needs.
2. The safe enables founders to raise early-stage funds without having to do a premature equity round. The tax laws create problems for startups and their founders if they raise money from outside investors too early in exchange for stock grants. This typically winds up putting an unacceptably high price on the common stock, creating tax risks for all concerned and also lessening the value of incentives that can be offered to key people going forward (fuller thoughts here: https://news.ycombinator.com/item?id=6849648). If first outside funding is to be deferred, though, the perennial challenge becomes how to fund the interim process.
3. The convertible note meets this need by combining the attributes of debt and equity instruments. The investor loans funds to the company and the company signs a note promising to repay the principal with interest. If, however, the company can do a qualified funding before the note matures, the debt converts into preferred-stock equity on the terms struck with the equity investors at first funding, usually with a price discount, sometimes with a price cap, and typically with merger-premium protection for the converting noteholders for the added risk they take in being early in the game when risks are at their highest. In that case, the debt vanishes and the noteholder becomes an equity holder and everybody wins in terms of optimal positioning of their respective stakes in the venture: founders have gotten their cheap stock that they can hold until a liquidity event, at which time they can sell typically for long-term capital gains and with no intervening taxes to pay; noteholders have gotten their equity stakes with all protections and with no-less-favorable pricing than that offered to the preferred stock investors who presumably have negotiated a good, arms-length deal for themselves; the company avoids a too-early high repricing of its stock so it can continue to offer good incentives to new team members as they join; and the company does not usually have to fool with 409A valuations or with other strings and formalities attending the bringing in of investors via equity rounds. All of which is great. But debt is debt. And, unless and until a first funding occurs, it must be carried on the balance sheet as debt. Debt also carries interest. And when it comes due, the noteholder has a legal right to sue for its repayment if it is not paid. If the noteholder wants to extend the term, a series of formalities are required to do so and, in their absence, the parties stand at legal risk.
4. The convertible note supplanted an earlier form of convertible note used many years back by which individual investors would see startups as being much akin to small businesses and would loan the money to the venture with the primary aim of making a good interest return on their investment. This might be called an "optional convertible" note and I remember doing many of these back in the day as a lawyer. That sort of note saw the conversion right as a privilege belonging strictly to the noteholder. In the normal course, the debt was expected to be repaid with interest. It might even be secured with the company's assets as collateral. It might be personally guaranteed by the founders. These were all the normal lender protections expected by those who had the investment mindset of that day. The conversion was there as an added perk only: if the company happened to do very well, then the investor could forget about the debt as such and could instead elect to convert it into equity (very typically common stock and at a price set up front, at the time the note was signed). So, for instance, an investor would loan $50K at 10% interest at a time when the company had little value but could elect to convert at, say, $.50/sh at any time in the sole discretion of the investor. The mindset in this era, then, was primarily upon the debt as debt but with an equity kicker to cover long-shot cases.
5. This mindset all changed during the bubble era, when convertible notes came in to help solve the early-stage funding problem. With its "forced conversion" element, it not only combined the elements of debt and equity but did so with equity being the main focus of the investor. Few if any investors by that time were primarily interested in being repaid the debt owed by the company. The equity upside motivated the investment and the debt came to be seen as added insurance just in case the venture did not pan out as hoped. Because of its force-conversion attribute, it was regarded under law as a "security," which basically means that the investor casts his lot primarily with the managerial efforts of company management while forgoing legal rights intended to protect a debt-type investment.
6. The safe seeks to confer the benefits of a convertible instrument without carrying with it the baggage of debt. It would thus be regarded under law as a "convertible security." That means the debt protections largely go away for the investor and the investor places his bet almost entirely on the efforts of company management. Thus, if this instrument achieves widespread adoption, the investor mindset will have evolved over the years from "loan with equity kicker" (old form of optional convertible note) to a convertible-note-style security instrument with true loan features (today’s conventional convertible note) to a pure convertible security (the safe).
7. I think it should work beautifully in the YC context. Whether it will achieve widespread acceptance or not will depend on investor expectations. I am not so sure. After all, the earliest investors do take the biggest risks. Is it enough to compensate them with a discounted price or price cap at conversion? If I were to guess, I would say that it is enough in the YC context. But it will be interesting to see if investors generally come to feel this way. In effect, the safe does leave founders saying to early investors, "Give us your money and but wait on getting your equity: if it goes well, you get equity; if it does not, you get nothing and you have almost no rights." Apart from a very vibrant context such as YC, where investor demand is already high, I am not sure how well that will sell when all the investor needs to say in response is, "how about us just doing a convertible note instead." I personally believe that for the general range of cases the pull toward a conventional convertible note will be very strong, and founders will have real difficulty convincing investors why they should forego the benefits of a convertible note in favor of a convertible security where the only advantages to the latter lie strictly with the company. But who knows? The YC magic has worked before to transform investor mindsets (I vividly remember how horribly out of favor convertible notes were just a short while back) and it may work this time too. Whether it does or not, we can all be thankful that YC is doing great and innovative things to add to the vibrancy of the startup world, and the safe is one more thing to add to the list (kudos to their excellent lawyers as well).
One of the concerns I've heard from many founders and funders is that convertible notes or securities can place the founders at odds with the early investors when it comes to company valuation. In this case, the concern still remains whether the conversion is a note or a security.
The founders would want the company to have as large a valuation as possible at the conversion event so that the equity ownership for the amount raised is at a maximum for the founders. But the early investors (holders of the convertible note or security) would want the company to be valued lower so that their investment is converted to give themselves and not the founders greater equity, or at least up to the cap amount, if one exists.
And with regards to the cap, there's the issue that the investors are converted at a potentially much higher total equity stake than they would get if the cap didn't exist. This is because every dollar of valuation above the cap goes to increase the early investor's stake in the company at the expense of the founder who must convert them at the cap level. So the founders are thus disincented to increase the value of the company to any amount greater than the cap so as to have a conversion at a favorable level.
As such, this means that in practice the cap becomes a defacto valuation for the company at its next funding round, which is at odds with the concept that a convertible note / security allows the founders to defer the determination of the value of the company. The reason for this is that if a cap exists, the founders would not want a valuation greater than the cap as they would be rewarding the early investors at their own loss. It would not be less than the cap because then they are negotiating for a lower valuation, which is against their interests. And so, it would be precisely at the cap amount, which thus becomes the valuation.
To me, this still represents an issue with convertible notes or securities -- the placement of founders at odds with early investors with regards to valuation of the company at the conversion event.
The only real way to keep the early investors and founders exactly on the same page with regards to increases in valuation is to have the early investors convert as early as possible, or in other words, an ordinary equity / Series A style round. But this is something early founders are trying to avoid because of the uncertainty of the company value, the cost of the legal work, and requirements involved once you have third party investors.
George's writings on HN, from a seasoned startup lawyer who's been around the block many times and has much to offer, are incredibly valuable, and all of us owe him some gratitude for it as it is high quality and he is not paid for it. And I'm sure he has plenty of business to handle without doing it for leads.
However, like a convertible note, the Safe does not place a valuation on the company at the time of its issuance, merely a cap; and almost always it will be used only when no prior preferred round has established such.
So for 409a appraisals, which, for seed-stage companies, rely heavily upon expectations about a future round, there will be relatively little impact. Namely the preference of the projected future financing will be slightly smaller relative to the note scenario, for the reasons detailed in this thread. This will increase the common value a bit, but not much.
An exception might be if the appraiser bases his conclusions on a balance sheet metric that comes out differently without the liability you mention, which is not as common.
This point is incredibly important and one of the key downsides of debt from the company perspective, as convertible notes create outsized liquidation preference upon conversion. And when things don't go as well as you hoped, liquidation preference matters a ton.
Kudos PG et al. EXCELLENT work.
It makes me wonder if there is a way to craft something so that a WeFunder or some other crowd sourced funding group could build one with multiple people participating that would have a slightly higher liquidation cash preference and no stock.
Basically it would work like this:
A group of people pool funds to fund a SAFE note with a 2x cash liquidation preference. So the next time the company raises money, they set aside 2x (or 1.5x or what ever the note says) in equivalent cash to return to the SAFE investors.
The SAFE contributors get a simple return (liquidation preference / time before liquidated), the startup gets lift off and a simple cap table (the SAFE vanishes after liquidation). It puts a cap on the return the SAFE investor gets in exchange for a somewhat lower risk (the company gets to its series A).
As you have clearly pointed out, one of the bigger issues with convertibles is that they change over time in terms of their impact on the company. The SAFE fixes that by getting rid of the debt/loan aspect, and this would do the same but bake in a fixed redemption price.
An example, you get this thing (lets call it a BOOST), which is $100K with a redemption price of $125K. Now you startup goes 18 months, then does a series A raise for 1.125M$. They redeem the BOOST for 125K, pocket the $1M, and their series A investor gets their chunk of preferred. The 'rate' on our BOOST then is 25%/1.5years or 16.6% APR.
Example 2. Same deal except the series A comes 6 months later. Now the redemption in only 1/2 year gives an effect return of 50% APR.
Example 3. Company starts, grows to a going concern, runs for 5 years and then gets bought by BigCorp, and the BOOST is redeemed. Now its effective APR is 5% (actually less than that if you're not doing simple interest etc but it illustrates the point doesn't it?)
Example 6. Startup goes poof and dissolves. BOOST is effectively at the head of the line on distribution of the asset value.
Take $100K, divide it into $10K chunks, spread it across 10 different BOOSTS with other investors in them and spread the risk still further.
Yes. But lets look at it from a couple of different perspectives before we conclude they won't like that.
First we'll assume that the Series A is much larger than the BOOST redemption cost, anywhere from about 10x to 20x. We make that assumption because it the BOOST aka "seed" round is much bigger than that the Series A looks more like a Series B than a Series A, which is to say the company valuation isn't really in a place where VCs would jump in ok?
Lets put some numbers down which makes talking about it easier.
Lets say the Series A really is 9X the BOOST so in a post money valuation with 60 percent for the company founders/employees we're looking at a cap table that is
60% employee 60% Employee
36% VC 40% VC
4% BOOST 0% BOOST
Company value increases 5x and the company is sold for $25M.
Series A guy in the left scenario gets their liquidation preference + 36% of the remains (with participation) whereas in the right scenario they get their liquidation preference + 40% of the remains (again with participation) in the second scenario.
If the company is going to do well (and they assume it will) they do better by not having the BOOST guys in the cap table then they do with them there taking a percentage. If the company does poorly they still lose their same investment they would have lost anyway.
Things are simpler for the BOOST guy too, instead of managing dozens of small share holdings in small companies they get a smaller but faster return. This creates a reliable source of seed money for the ideas, which creates a larger pool of potential Series A investments for VC companies.
Meanwhile, the good companies aren't going to be likely to entertain financing on anything but terms like these, so fighting them just incurs an adverse selection penalty.
The same thing seems to have happened with convertible debt, which was preceded by financing mechanisms that were way, way more onerous for entrepreneurs.
This will be taken care by the market via the caps put on the Safe.
That's usually a bad way to make a legal contract. As an investor I'd want something a little more definitive.
Often that also includes certain revenue threshholds and/or time limits.
Does the "safe" have provisions for this?
and often but not always, the note will also provide that if the note matures hasn't been a QFE, then the note can convert into common stock.
Nobody wants to have debt repaid when a company takes off that you could have had early stock in. (And normally I think that convertible debt doesn't allow such provisions.)
Losing the amount invested (investment going to zero) is really, subjectively, not the "worst case" - because it's money the investors could stand to lose.
Instead, subjectively, the worst case (and related to a common investor fear, FOMO, fear of missing out), is making the original and only seed investment that launches the next Snapchat (or whatever), and then getting failing to own any of it due to something like the company not raising another formal round or otherwise repaying the debt instead. That's subjectively a much worse case, then having an investment go to zero, which is rather expected.
Losing 100% of the investment is the "default" case, not at all worst or unexpected, getting converted into equity at a very small and unsure company is the "good" case, getting converted into the next snapchat or whatever is the amazing lottery-winning case, and losing out on the next snapchat or whatever despite ponying up the cash is the worst possible case that you would kick yourself for forever, subjectively speaking. IMHO.
If people here make lots of seed-stage convertible investments they can say whether this matches their valuations, this is just my opinion.
When they repay the debt, you're not "stuck with none of it" you're stuck with indeed a x>0 portion of the company's value. Strictly speaking, you are just stuck. What escapes you is the upside of an investment that you <did not make>.
The right (but not the obligation) to make that investment on pre-defined terms is the defintion of an "option".
It's possible to think that they do, and that they make a choice based on adding up the dollar-value of alternatives, multiplying each by its probability, and summing the results.
If that were the case then two things would be true (among many others):
Debt that can be repaid would greatly increase the chances of a landed investment (investment being made in response to pitches), since there are many, many cases in which a small group of people formed into a company can repay an early debt, even if the company ultimately folds. All these cases would detract from the down-side. This would, in theory, tip the investment in the favor of being made. For example, if a company has a story that you might make 15x your money in 2 years, but you believe there is a 1 in 15 chance of this happening, then it should objectively make a big difference whether (or how many) out of the other 14 chances repay your money. If all 15 repay your debt, and 1 in 15 makes 15x, then that's a good investment, slightly beating the alternative places you could park your money. On the other hand if most of the cases end up losing 100% of your investment, that "should" make the investment quite a bit worse. For example if 14 in 15 lose the investmnet and the fifteenth makes 10x in 3 years, then that is not great.
But htis is not how investors actually make their decisions.
No investor will give a seed that has a 8 in 10 chance of being repaid (as debt). Period. They just don't.
Firstly, they are looking for that big, big win. And secondly, they want to skew the probability distribution toward that win.
An investor far prefers: (package 1)
0.0125 probability of massive, huge, breakaway hit: 500x
0.05 probability of HUGE growth: 50x
0.9375 probability of total loss (goes to 0 in 3-7 yrs)
0.0125 * 500 + 0.05 * 50 = 8.75x average.
to: (package 2)
0.05 probabibility of total write-off
0.15 probability of small win (e.g. 10% p.a., i.e. debt repaid)
0.459 probability of "failed" i.e. moderate growth (5x)
0.34 probability of successful growth (20x)
0.001 probability of 500x
0.15 * 1.1 + 0.459 * 5 + 0.34* 20 + 0.001 * 500 = 9.76.
Investors aren't trying to go for the second package - i.e. making a shot at a very sure 20x and maybe missing it and making 5x. That's not what they make seeds into, $2.5M companies they can believe in at $125K (20x).
It's just not what they're about.
That is not the story that is interesting to these investors. They would far prefer the first package (as far as I understand) that comes with a bigger shot at the moon, even though this greatly diminishes the overall return. Tons of companies are very close to being worth $2.5M, and not really more, and don't need much money. They're just not that interesting.
A second way you can know that this isn't a case is that nobody would even look at an investment like (package 3, hypothetical)
0.0001 probability of 75000x
0.9999 unknown result
Well, it means investing in something that will grow to 75,000 times its size with a 1/10,000 chance of doing so.
It means somehow onboarding 10,000 people - investing $200K into 10000 companies - that are all saying they will turn it into into let's say a $60B company.
Do you see anyone investing $200K at a $800K valuation into 10,000 nascent companies that are saying they will be $60B companies? And showing very, very little chance of doing so - 1/10,000?
Of course not. The amount of money required to invest in, say, 10,000 such companies is $2B. Taking $50K of it would cost $500M. Some VC's have this.
But do you see any VC's with massive, massive onboarding programs where they are pouring $50K into 10,000 companies, that each give you only 1/10 000th confidence that htye're actually the next Apple or Google?
No. It's just not being done. You can play with the numbers but they show that nobody is summing in this way.
They want a different distribution that they can believe in. They're fearing on missing out on something big. Not trying to play the numbers to make something absolutely extraorbital.
You dismiss the notion of precision in the <Legal> sense. Which is what we are talking about here. EG
But precision isn't really required, because it is a huge mistake to think that investors use <lawyers>.
The problem with the earlier discussion is that it confuses concepts (zero, non-zero returns) and actions (investments made, not made) etc.
The precision needed simply relates to the classes of actions taken (or not) as well as the classes of contracts negotiated (or not), in other words.
But far from it. It is extremely rare for debt to be repaid instead of converting, and even if it did, that would be a terrible outcome (and not in the way the OP meant.) Nobody wants their convertible debt to be repaid! (As debt).
They want the company to grow big, or die trying. Really.
So no, they DO derive economic benefits, but it may be a long time coming.
[Edit: this is almost the same as convertible notes. The only difference is that as a debt holder they may be able to force a resolution at maturity, but that is usually to the detriment of the company. But as the preamble says, most angel/VC investors dont actually want to be a debtholder"
- in the acquisition of a company with an MFN SAFE, it says that the instrument can convert in to common at the fair market value of the stock. Isn't that the FMV the purchase price? So isn't that the same as getting your original money back (no matter how successful the company may become)?
Regarding pro rata rights it says:
Do SAFE holders get pro rata rights? <snip> This pro rata right must be in either the Equity Financing documents or a side letter.
Is this saying investors need to add pro rata rights to your SAFE, or that they only get them if the subsequent preferred financing has them?
I know YC has seen MFN usage in the "everyone gets $100k" scenario, but I also could see them useful for family and friends rounds where an unsophisticated investor with a conflict of interest wants to put in the first $10k but not set a price. In that case, a default conversion might make sense as an option.
I understand the advantages of notes, but I found that many investors don't like it. We had many who agreed to a modest priced round, but absolutely wouldn't do a convertible note, and yet Paul says most YC startups make do with the notes. There is a disconnect somewhere here.
So am I the exception from the norm, or is YC the exception?
My question is different - to what extent investors find note financing acceptable/appealing? Is it only YC companies that get the privilege? Is it a Silicon Valley thing, not used much elsewhere (like Seattle)? Is it used everywhere, and I just happened to be unlucky with it?
We closed a note with Dallas investors that DID have experience w/ west coast deals that featured a cap and a discount.
Is there anything special that makes this substantially different from a vanilla option, or is it just that a Safe is standardized in an easy to use way?
You're right about securities; the security usually exists prior to offering a contract on it. But even then it gets a little more complicated. For instance, I can write a naked option (an option to buy a security I don't even own). They're pretty flexible instruments, and I'm not sure how Safes are substantially different. That having been said, it sounds great for founders and funders, since it's far simpler than the alternatives, and I'm shocked no one has thought to do this before. Kudos to the YC folks for having the insight to set it up.
But agreed, kudos to YC :)
Is there indeed a statutory or regulatory requirement to that effect? I'm not an attorney and you are, so you'd know better than me, but it's my understanding that "option" applies broadly to contractual obligations and rights to sell/purchase property or rights at some sort of preordained terms, conditions, price, or whatever.
It's entirely possible that I'm missing a subtlety, and I'll follow the discussion to learn what that is.
In that case of your ISOs, those would be tied to the existing common stock of the company. While the actual shares that you might exercise on aren't yet issued, the class of stock itself exists and the terms are set.
The next thing I'd like to see out of YC legal is some sort of over-subscription pre-sale. Something like a combined participation right/"first right of refusal"/put option that companies can sell to investors when they are hot to guarantee their future access to funds.
I'm really more interested in whether there are significant structural differences between the two schemes.
So, in the end, we wound up paying a "convertible debt tax" to the government. I'm actually surprised this comment hasn't come up yet; I would have thought the convertible debt tax would be somewhat common.
it's not an option because the purchase price of an option is lost to the seller no matter what.
it's not a loan because it doesn't have to be paid back on a schedule.
so basically it's more like a convertible security deposit.
Does this give YC an ability to set a lower cap because it has reduced the investor upside in a forced conversion?
If I were an entrepreneur, would I continue to raise multiple safe rounds and keep pushing the cap on the safe up? That would make the most financial sense to me as an entrepreneur. I'm not sure investors would want that, but it creates a large incentive for the entrepreneur.
Why is a forced conversion bad? I always thought a timeline was a good incentive to create value for investors, and to optimize around timing your fundraise with your cap amount.
How do you compensate investors for time value money if the deal takes a long time to get to the next round when there is no forced conversion or accrued component?
Consider also how much harder this will make private placements.
"The table below sets forth a comparison between the Standard Preferred and the SAFE Preferred, as each would be described in the company’s certificate of incorporation:"
Reading the SAFE it mentions "SAFE Preferred Stock" and seems to partially define it. Does this mean you must have "SAFE Preferred stock" defined in your articles of incorporation to use a SAFE, or can the SAFE stand alone?
Since [convert] = [bond] + [option] what we do is make [bond] pay no coupon, and strike the option weirdly and make it look like it is a new (disruptive?) form of investment, when really it's tax/regulatory arb.
Caveat: I am not a lawyer or banker, nor have actually read the documents, though I did read the OP.
Does this make sense? If not, I can try to write it in more clear English.
While this would be sociopathic behavior, what would stop this from happening?
1) Start company
2) Raise 1 million dollars on SAFEs
3) Distribute 1 million dollar dividend
4) Dissolve company
So if a company manages to get to a pre-IPO stage, will the accounting for these warrants be more complex? It sounds like trying to value one of these warrants might add some/a lot of extra work.
"has the advantages of convertible debt without some of
1) What is the current problem with convertible notes?
2) How does this solve that?
From the article, this new financial instrument is attempting to solve the problem that Convertible Debt has a set of restrictions: term limits and interest rates close to market rates. This causes lead to complications, when the note converts, or when the term expires.
This solves it by no longer issuing "debt", but instead the right to buy stock at an agreed price. This is similar to a Warrant, which is typically used for advisor compensation.
Regulation is so thick on the ground that operating in an unregulated industry is considered a business risk, because you know the regulation is coming, but you don't know what it will be. There are rules for everything.