UnSAFE Posted 2024-December

Caution: This post is going to upset some people, especially over-confident yet inexperienced "investors". 

Ultimately, if you pitch investors, you will need to get to the specific legal thing they will give you cash for. That thing is a contract of some sort, where they give you cash in return for certain rights regarding the company. (Equity, convertible debt, and even SAFEs are all contracts.) There is a huge amount of complexity built up in that to prevent bad behavior, a lot of it to prevent bad behavior from happening again, but ultimately that's all there is to it. The rights specified in the "security" or "instrument" typically have a direct impact on risks, returns, or both for the investor. And investors - real, professional investors - notice.

In this context, let's consider Simple Agreements for Future Equity (SAFEs). A few years back, Y Combinator (in particular) came up with SAFEs as a means of reducing the friction in investment deals. Who needs a 20-page convertible equity agreement, and the costly lawyer to review it, when you can have "simple" for raising - say - a $1.5M pre-seed round? Essentially, why not democratize the "friends and family - trust me" bootstrapping that many companies do already? It makes sense.

But "simple" strips most all of the protections for investors, significantly increasing risk. In 2020-1, under the Zero Interest Rate Policy (ZIRP), this did not affect the investor calculation all that much. Times are different now. I will discuss the over-simplification of SAFEs below and how they are now adding friction to deals, but first, let's look at the basics: cap and discount.

Caps

The Valuation Cap - or "cap" - of a SAFE is the maximum valuation of the future equity round that investors will have to pay. Read that again. The cap is not a valuation. I repeat, the cap is not a valuation.  The way a cap works is this: in the future, when you raise the priced equity round, the SAFEs are converted at a share price of:

If the price is less than the cap, the SAFE investors pay the price that the equity investors are paying.

If the price is more than the cap, the SAFE investors pay at the cap.

For investors, the cap represents a protection against a scenario where the company raises money at an outsize valuation and dilutes the SAFEs to nothing.  Since no one knows the price of the Future Equity, this is important. But notice - again - the cap is not a valuation.

So think about this for a moment. Note that investors are rewarded if you raise above the cap in the future: they are getting shares at the cap price, which is below the current price being paid by new money so they get more shares per dollar as compensation for the fact that they took more risk for a longer time (i.e., higher cost of money and higher opportunity cost) than the new money. That's how it should work.  And if you raise below the cap? The SAFE investors at least do no worse than if they'd waited. Remember, you are selling your investment - the cap is an incentive to buy now instead of later.

But somewhere long the way, people started thinking SAFE caps are valuations, now or in the future, instead of simple pivot points in the investor return curves. So caps crept up to what the founders hoped they'd be when they got that future equity round. And founders being optimistic to a fault - or they would not have founded a company - the caps kept going up. Just a few months ago, I had a company with ~$1M ARR try to raise with a SAFE cap north of $40M! As I said in my intro, you are raising money now not for the super-optimistic future you believe in.

And think about what happens if things do not follow the super-optimistic vision you have. That is going to happen 90% of the time, at least, but the simplication of a SAFE is that these scenarios are generally ignored.  Will you be able to raise more money at the same high cap... even though you have not performed up to plan? Will current investors re-up to help you when you've already shown that the ROI for them you'd previously pitched won't happen? And if things do go well, are new investors really going to want to pay that price in order not to be diluted by the SAFE holders?

Plus here's a subtlety you probably did not think of: if the cap is high, the best scenario for investors is that you struggle in the short term and therefore have to raise below the cap. Yes, investors want you to succeed long term to get to an exit... but short term, with a high cap in that early round, not so much. You really want investors on your side, helping you with contacts and advice, not ignoring your calls.

In general, a lower cap will serve you well. Yes, in the wildly successful scenario, you will be diluted more. If you are wildly successful, that added dilution won't make much difference. However, in all other scenarios... in the vast majority of cases... you will be better off having chosen something reasonable.

Discount

The other main term in a SAFE is the discount and it works precisely like you'd expect: the investors pay a percentage off of the equity's price. Why? Because of the time value of money. If I put a dollar in the bank, I get paid interest. For professional investors, the "bank" can be the US Treasury and they can get the Federal Reserve interest rate risk free as well as the liquidity to get their cash at any time. Why would an investor give you a dollar today to get equity in 1-2 years at the same price that the new money is paying? The investor could put that dollar in the bank, invest it when the equity round happens, and net the interest on a proposition with less risk.

Under ZIRP, this hardly mattered.  If interest rates are zero, my dollar today is worth a dollar tomorrow, so I might was well invest today. But - news alert - interest rates are 4+% now. And those are risk free.

So, the discount in the SAFE needs to compensate for both the interest rate and the increased risk (and reduced liquidity) of the investment. Offering 10% is laughable. Offering no discount... as one pitch I recently saw did... conveys a fundamental lack of understanding of the Investment Case. Frankly, I viewed it as an insult from an over-confident entrepreneur and an instant red flag.  

Don't be that guy. Appreciate the Investment Case as if it were your own money. Offer a decent discount... 15% if you think you will raise equity in 12 months (you won't, but if you can make the case...) and 20% if it's 18-24 months.

Zombies and Other Terms

What is the worst outcome for an equity investment? If you answered some version of "the company goes broke" or "your investment goes to zero", you are naïve.

The worst outcome is a zombie... a company that bumps along with slow growth and marginal profitability. Such companies  can survive a long time, providing neither a profitable exit nor a tax loss for the investor... thus tying up their capital forever. It's frustrating for everyone, with no end in sight.

In the '90s and '00s, convertible debt evolved terms to handle these situations. The details are beyond the scope of this essay, but suffice to say, a simple debt agreement with an attached conversion option became a lengthy agreement with different conversion and liquidation terms, arbitration clauses, and more. How do you get to a 20-page agreement?  You start with a simple 5-page agreement and then account for all sorts of bad scenarios.

And that is what is happening in SAFEs... at least somewhat... with the striking exception of Y Combinator itself (whose latest template makes it easy to create no-cap, no-discount SAFEs).  SAFEs are evolving from "Simple" to "Complex" - to CAFEs - and getting longer.  And that, coupled with SAFE's well-earned reputation for a dearth of investor protections, is swinging the pendulum back to convertible debt for rounds beyond pre-seed. 

Conclusion

While I expect pre-seed to remain SAFE, I expect fewer Seed rounds will be, especially if the Seed has a VC lead. Get familiar with the options for investment securities. Set terms that respect the investors and their role in your success. And get good legal council. Yes, that's more friction than 2021, but that's the reality.