Why SAFE Converts Aren’t So Safe

Founders in early stage companies face the constant challenge of raising money.  For many ambitious entrepreneurs, SAFEs or other convertible securities are attractive funding options because they provide capital-hungry startups a fast route to raising funds without the resistance that comes with pricing.  For this reason, SAFEs have become increasingly common, especially in early rounds involving non-professional investors. 


First introduced seven years ago, we now have enough historical data to highlight the variety of problems and friction-point that SAFEs and other “mini-equity-rounds” can create — designed to alleviate immediate challenges for startup companies, SAFEs and their equivalents actually cause significant problems for founders and investors in the long term.


What is intended to be a win-win for entrepreneurs and investors is actually lose-lose in far too many situations. 


Having invested in private, venture and growth companies since 2008, we’ve seen far too many entrepreneurs choose SAFEs as the route of least resistance without considering the possible problems and difficulties they are creating for future funding rounds.  They can also lead to unnecessary conflict caused by misaligned incentives for founders, current investors and future prospective investors. So, before embracing the quick stimulus that a SAFE may provide, founders need to be well aware of the possible headaches they’re creating for themselves down the road. 


Here are three key points to consider when evaluating the use of SAFEs:


# 1 Consider why you are deferring the pricing decision


We understand the struggle that founders face when it comes to raising capital.  Evaluating a start-up company is nebulous at any stage and in the first rounds of funding the methods for pricing should rely on the projected valuations of future rounds. This  requires the ability to forecast valuations. The market intelligence required to make such forecasts is only available to firms who have access to the terms of a reasonably sized sample of priced deals to use as comparables.


It’s no question why SAFEs would be attractive to founders in this context –

  • Founders can delay the valuation of a company until the business model is more established, and hopefully, more valuable.
  • It’s a speedy way to raise the capital to achieve growth, deferring the most contentious negotiating point: valuation
  • Quick funding solves one major problem while you’re in the heady-phase of getting things up and running.

Investors also perceive a benefit from this funding model —

  • They don’t have to deal with disputes with founders over pricing
  • They can rely on a potentially more sophisticated investor to put the work into establishing a valuation at a later date
  • They get a guarantee of investment in future rounds at a discounted rate


On the surface, this seems very attractive for all parties. However, when you look at the longer term effects, founders and investors are not alleviating discomfort, they’re only delaying it.  And like all problems, delaying the inevitable “tough conversation” ultimately leads to even bigger problems.  


SAFEs present such an appealing option that some founders almost seem addicted to the tactic, recycling the strategy over the course of multiple funding rounds. With each cycle, they reduce their own equity in the company, sacrificing long term benefits for short term gain.  While we are not dismissing this strategy outright, founders and investors need to take a hard look at the motivations behind their actions and to be realistic about the possible outcomes. 


#2 Being Honest About The Valuation Cap is Essential


A key term in SAFEs that is dangerous is the typical cap structure, where the conversion price of the safe cannot exceed a certain valuation. Many problems arise because, by the very nature of SAFE’s, there is not much discipline or incentive to be meticulous or thoughtful about valuation caps. 


All too often, when the cap is determined the expectations are misaligned — the founder assumes that the future pricing round will be above the cap with the perceived notion that a priced round below the cap is a “down round”. Meanwhile, the SAFE investor feels that the future round could happen below or above the cap, at a fair price set by a sophisticated VC setting the valuation. This misalignment can lead to the company taking more risk than either party intended and anchor expectations in a way that hampers the pricing of the next round.  


All too often, caps are set too high for the wrong reason, resulting in negative impacts. 


For example, investors may compete with each other in early rounds by setting the cap higher to entice founders to accept their investment. They do this with the idea that if a priced round happens at a lower valuation, they will get a fair price. However, since setting the cap sets the founders bias towards not raising below that established cap, a circular set of incentives is established, leading founders to potentially take on more risk than necessary, making them more vulnerable to failure.


This also creates divergent incentives between the entrepreneurs and investors. The founder will take more risk than the SAFE was intended for. They will delay funding or raise another round of SAFEs until valuations are above the cap to avoid being considered a “down” round. This is contradictory to the idea that the SAFE round is deferring the pricing decision since the cap itself is in reality influencing the pricing of the future round. The combination of an almost arbitrarily set cap and its significant influence on pricing of future rounds leads to unintended risks to the success of future financings.


#3 There’s Value in Understanding SAFEs from a Seed-Series A VC Perspective


Clearly, as VCs ourselves, we have a personal stake in this particular issue but it is very important that founders understand this point of view — 


While SAFEs may provide the bridge that gets to the next level of development, multiple SAFE notes on various valuation caps can have a significant and negative impact on the financial viability of a company. In some cases, the cascade of notes like these eat up so much equity in a company that the math of the next round puts it outside the ownership targets of the VC. 


A SAFE funding model has the potential to cobble a company in the long run by limiting the number of VCs that a founder may be able to deal with at various cycles. 


In an even worse scenario, too many notes may inhibit a company’s ability to find a new lead investor at all.  SAFEs could create a situation whereby a company wouldn’t be able to meet targets without recapitalization or a complete restructuring of the cap table.


Again, doing the math and fully understanding the cost-benefit of notes is imperative for the success of any investment.


Are there cases where a SAFE is appropriate? Absolutely.


There are times when using a SAFE is the appropriate choice. Those are when the reason is not the deferral of pricing but a short bridge to a priced round. Caps are intended to reflect the valuation this firm will hit within a short “bridge” time and discounts are to reward investors for giving the company more time and runway.


One case would be that a firm has some competing term sheets that set the pricing and the company feels that another 6 months of performance would lead to a large increase in valuation. The capital required to achieve these KPIs is much less than the full round. As such, a SAFE with a cap of the pricing from the rejected term sheets would make sense as long as the all parties are committed to a financing being completed in the short term.


Another case is the historical reason for early stage convertibles, namely bridging to a round. If a company has a term sheet that will take time to close, then issuing a safe to existing shareholders or investors who would follow the lead into the future round with a cap at the expected future round valuation makes sense.


In both of these situations, the cap is not set arbitrarily. Instead, it is a valuation that reflects the current market conditions.


Is there an alternative solution to a typical SAFE? Absolutely.


In our experience, a founder should always prefer a priced round that reflects the current market for the next rounds of financing. This means that the founder is taking a more realistic view of the valuation at earlier stages and resolving themselves to provide a path for early investors to make a good return.


That being said, we recognize that founders need some way to raise money from less sophisticated investors who do not have the market intelligence to price a deal.


We would suggest that a fairer and more aligned structure for both the founder and any investor, especially for very early raises with angel investors, would be a round composed of converts with no cap and a discount that aggressively increases over time to compensate for delays in the next round (similar to an interest rate on more conventional convertible securities).  


This would align the incentives of both parties and distribute the returns over the risk taken between the time of the SAFE investment and the priced round. We would go further to suggest that there be no cap, and a 20% discount over the first year that increases at an effective 20% IRR thereafter.


A security designed in this way would keep the interests of both parties in line with one another by providing an economically reasonable return expectation to SAFE investors while also mitigating headaches of unintentionally setting a valuation expectation for future rounds.


Whether or not founders and early investors choose to take this alternate route for founding is still a matter for debate.  Nevertheless, it is a valuable scenario to consider when evaluating a strategy to grow a company.  Building a business is a long process.  Founders and investors need to frame their approach to growth with that in mind.