A friend of mine, who would prefer to remain anonymous, is a successful investor and also an expert in corporate governance. We’ve invested in a few deals together and over time, my friend has became comfortable with SAFE notes, somewhat to my surprise. Here’s a write-up from my friend on why:
You asked me to write about how I got comfortable with the YC SAFE as an investment vehicle. I believe we are on the same page, but for clarity I’m going to say that this discussion is about using a SAFE vs. convertible debt for first financings of early stage companies. There are other instances in which I might be agreeable to a SAFE; but, as we said, we want this to be short.
1. I will do only a SAFE with a cap. I will not do a discount structure, SAFE or convertible debt, because I am unwilling to let a company use my money to increase my price. When companies say that the discount is to compensate for the price change over time, it often is the case that the company wants a long period, perhaps two years, before the conversion and the discount is around 20%. If a company can’t increase its value more than 20% in two years, that investment isn’t interesting. This said, if a company wanted to give me a cap and a discount, that would be okay of course. (Historically, convertible debt typically did not have a cap and the tenors were short. Tenors have been longer for quite a while now (for over 10 years), but I’m only recently (past 2-3 years) seeing capped convertible debt.)
2. On the topic of a SAFE not having an interest component, my response is that this is only a pricing issue.
3. On the topic of a SAFE not being superior to equity, this simply isn’t important to me as a practical matter. I don’t recall ever seeing a convertible debt that got repaid. In a bad situation, there generally is no money to repay the convertible debt holders and, if there is any money, the SAFE’s liquidation preference puts it before the common anyway.
4. So, you probably can see now that the “benefits” of convertible debt over SAFE are not important to me as a practical matter. This brings me to the fact that I’m not only comfortable with a SAFE, I like the structure because it is administratively better for the company – no debt on the balance sheet, no dealing with the administrative burden of changing maturity dates (which typically happens as necessary), no fussing with interest calculations. Importantly, the legal fees for a SAFE typically will be cheaper than the fees for convertible debt.
5. I have had the YC SAFE reviewed by multiple lawyers with relevant expertise and they are fine with it.
6. This final topic you asked about is more complex – the risk of getting hammered by the next round of investment. This always is a risk. Even preferred issues with extensive investor protections can get hammered if a company isn’t performing well and doesn’t have choices for new money, and this situation can be exacerbated when the new money doesn’t care about its reputation. There also is the very unfortunate instance of the company not caring about its early investors, and it collaborates with the new money to hammer the existing investors. In this instance, my opinion (which I have discussed with lawyers) is that a SAFE is in a stronger position than convertible debt because the company’s board and management have a fiduciary duty to the SAFE holders since the SAFE is equity. Fiduciary duty to debt exists only in the face of insolvency. It’s a bad situation when reliance has to be on fiduciary duty, however.
Bottom line is this: is the company committed to integrity and is it capable of performing such that it can attract new money that will treat investors fairly? It is much more about this investment criterion than about the instrument. (As an aside, I will say that I caution both companies and investors regarding situations in which prior investors aren’t respected because guess who is going to be disrespected next? There are situations in which investors reasonably take a hit for poor performance as more money is sought; but, don’t do business with the bad guys.)