What’s the difference between SAFE and a convertible note?

SafeFor the past 20 years or more I’ve seen convertible notes as the best instrument for founders taking on a seed investment. Selling equity when you are a very early stage startup is very difficult for one simple reason: it’s impossible to set a valuation that is fair for both the entrepreneur and the investor. It’s a zero sum game: investors want more equity for their dollars and founders want more dollars for their equity. And there is only 100% equity to incentivize not only founders but future executives and staff. Trying to predict the future value of an early stage company can become an exercise in frustration.

So you might say, why not just get a loan? But banks and any other financial institutions want one important thing for a loan: collateral. Collateral is something of value – your house, your car – that they can repossess if you default on your loan. But banks aren’t about to repossess your code or your prototype – neither has value to them. Thus comes the convertible note, which is a type of debt that makes sense for both the early stage investor. i.e. angels, and the founder, and it has been the standard for years.

There are two key features to a convertible note, the discount and the valuation cap. The discount rewards early investors for taking on larger risks than later investors by offering them the right to obtain shares at a cheaper price than that paid by Series A investors once the Series A round closes. So if Series A investors pay $1.00 per share,  holders of convertible notes – and a startup may have several – get to convert their loan amount at typically a 20% discount, thus enabling them to buy shares for not $1.00 per share but 80 cents. The market tends to set the typical discount rate, thus eliminating a lot of negotiation and frustration between founder and investor.

The valuation cap sets the maximum value of a company when the Series A closes. Again that provides a benefit to the holders of the convertible note as the know in advance the minimum number of shares their loan will convert to. In other words they know the worst case scenario in advance. Setting the cap, however, can be more contentious than the discount rate. Just like ordinary loans, convertible debt contain an issuance date, an interest rate, and a maturity date. But repayment is made with equity – or not made at all if the company goes belly up before raising a Series A.  The investor has the option of choosing between the lower of either the discount or the cap conversion. The conversion price that’s the lower of the two methods results in more shares issued to the early investor upon conversion.

So what the heck is SAFE and why was it invented? SAFE is an acronym that stands for “simple agreement for future equity” and was created by the Silicon Valley
accelerator Y Combinator as a new financial instrument to simplify seed investment. Here are the key variables and how SAFE differs from convertible notes which I have taken from Melissa Hollis’s article Seed Investment: Comparing SAFE and Convertible Notes with changes and annotations based on my experience dealing with convertible notes. 

1. SAFE Offers Simplicity by Minimizing Terms

One problem with convertible notes is that they have a lot of moving parts. And every lawyer likes to write his own version – similar to NDAs – there is no industry standard convertible note. SAFE simplifies things by eliminating two moving parts: the interest rate and the maturity date (these are hangover variables from typical bank loans).

2. Different Points of Conversion to Equity

There are two different points when it comes to triggering conversion of the loan to equity.  A convertible note can allow for the conversion into the current round of stock or a future financing event, a SAFE only allows for a conversion into the next round of financing. So again, SAFE is simpler.

SAFE converts only when you raise any amount of equity investment unlike convertible notes which trigger only when a “qualifying transaction takes place” (more than a minimum amount dictated on the agreement) or when both parties agree on the conversion.

Finally raising common stock doesn’t trigger a conversion for a SAFE investor (keep in mind that VCs always invest in preferred stock, with its preferences over common stock).

3. The Valuation Cap

Typically convertible notes come with a valuation cap and SAFE may not. But as above, this is the sticky negotiating term with either convertible notes or SAFE. However, by foregoing a valuation cap  you could be diluting your shares and your future investors’ shares when you go to raise your Series A.

4. Early exits

What happens if the company is sold before raising a Series A? Both convertible note and SAFE investors give the investor a return. SAFE gives the investor the choice of a 1x payout or conversion into equity at the cap amount to participate in the buyout. Obviously who the acquiring company is and the state of their stock will decide which route the investor takes. Convertible notes typically have a 2x payout.  Here’s a case where the convertible note is actually simpler than a SAFE, but may make it less attractive to the investor.

5. SAFEs have no interest rate

SAFES are not debt, they are defined as a warrant. A warrant gives the investor the right, but not the obligation, to buy shares at a certain price before expiration. Convertible notes are loans, and as such carry an interest rate, which in my experience generally runs about 8%. Again SAFE has fewer moving parts, meaning fewer elements have to be negotiated, providing a simpler instrument with an advantage for the founder.

6. Maturity date

If you have been paying attention to this point you know that SAFE is not a debt instrument so it doesn’t have a maturity date. Convertible notes do. So what happens when you reach the maturity date of a convertible note? You either have to pay back the principle plus interest – just like a normal loan or you convert the debt into equity. If you are running out of money you certainly can’t afford to pay back your note! So SAFE is a lot safer in this regard. I’ve yet to hear of a company that paid back its convertible note!

7. Administration Fees and Services

Typically neither a SAFE nor a convertible note comes with any admin fees or need for professional services, e.g. legal or accounting, although theoretically a SAFE could trigger the need for a fair (409a) valuation to formalize your company’s common stock value.

The bottomline is that SAFE is simpler, with fewer moving parts and thus less chance of getting into a fractious negotiation with your investor. The best way to determine which instrument is best for you, however, is to work through the decision trees for both options and create cap tables on a Series A for both options. Like any decision, scenario planning is usually the most effective means of decision making. That means translating legalese into practical business consequences. Get used to it, that skill will often be needed by any startup that grows successfully.

Being neither a lawyer nor an accountant I can’t give you a qualified opinion on which is best for the founder. Offhand one would think that an instrument created by an investing company, i.e. Y-Combinator would favor the investor. But I believe the reason that Y-Combinator created the SAFE is that at the extraordinarily high volume of startups it invests in the efficiencies of simplicity of SAFE outweigh the small advantages to the founder.

Why shouldn’t you raise money now?

NowLater-compressed

I’ve outlined numerous reasons to raise money now – the pros, as it were. But raising capital is a two-sided coin, usually many of them, so here are the cons.

Distraction

The name of the game in startups is focus. Raising capital is a very difficult and intense process that will distract the CEO/founders from the venture’s main business: building product and acquiring customers. In fact, I can’t think of much else that is more distracting other than a major rift between founders. It can easily take six months from the time you start your capital raise to the time your funds are wire transferred into your bank account. That’s a lifetime in a startup.

Resource limits

Draining limited resources – namely the CEO/founder’s time – is perhaps the biggest reason to avoid raising capital, especially from venture capitalists, who can drag out the process unless you can create a strong sense of urgency, which probably has to be a very real threat they will lose a deal they really want. CEOs in startups are completely different than CEOs in mature companies, as CEOs are also individual contributors, either in sales, business development, product development, customer support or all of the above.

Dilution

When I was raising capital way back in the last century the rule of thumb was that VCs would take about 35% to 40% of your equity in the Series A round, leaving the company with 60% to 65%. Today I’m hearing that it’s more likely 50%. I only have a few data points on this, so check with your friends in the founder ecosystem. VC’s also insist on the founders setting aside roughly 20% for future hires – note well that the company takes this dilution, not the VCs! So the founders now are left with about 40% to 45% of the company they started – a minority interest! There are two good ways to avoid dilution: one, finance your company with customer revenue, grants, and friends and family money; the second is to build substantial value before raising money: large numbers of customers, very rapid growth in customer base, and running the company on customer revenue and perhaps friends and family money. The longer you wait to raise capital the less equity you have to sell to acquire the same amount of funding. That’s why it’s not now, but perhaps later.

The battle over equity allocation

Here’s another rule of thumb, mine: the earlier the stage of the company the more difficult it is to allocate equity fairly. For example, let’s say you haven’t yet built your product. How do you measure the contribution of the tech team? You have to bet something on the future value of their contributions. Similarly how can you evaluate the contribution of sales, marketing or business development team members when you are pre first customer ship or even pre-revenue! Again waiting until you hit some major milestones like first paying customer or even breakeven will enable you to better evaluate the contribution and thus the equity allocation of each team member. See Chapter Six: Reward Dilemmas: Equity Splits and Cash Compensation in The Founder’s Dilemma by Noam Wasserman.

Giving up control

With a Series A round your investor will most certainly take a Board seat. If you syndicate your round you might end up with two VCs on your Board. And if you have given up 50% of your equity on the first round the second round will put the VCs firmly in the driver’s seat, if they aren’t already. As CEO are you prepared to report to a Board of Directors? Are you certain your investor is as much aligned with your interests as possible? Giving up control is one of the major reasons I hear from founders for not raising capital, now.

Constant pressure for hyper-growth

Once you accept VC money you have bought a ticket on a rocket ship which must reach escape velocity or fall back to earth in a ball of fire. The pressure to grow at virtually all costs will be unrelenting. If you thrive under this type of pressure that’s good. Otherwise you might want to think of another way to finance your venture.

To sum up, the key word in both this and the previous post on reasons to raise capital now is now. You and your team need to establish measurable milestones for at least the first 12 months of the company’s life. Then you need to decide what will be the triggering event to start to raise money. Absolutely the best time is when investors are calling you. That’s why, while you are building your product and your company, you also need to create buzz. Buzz will help generate incoming contacts by job candidates, prospective partners, and it is hoped, investors.

Finally if you decide the time is now, take a look at my post Are you investor ready?

 

 

Why raise money now?

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We got into this discussion at a recent MIT mentoring session. So I thought it would be helpful  to list some of the ways it is worth raising money, primarily from VCs.

Validation: With all four of my venture-backed startups I found that prospective partners, customers and even vendors saw us as more credible after raising a 7-figure Series A. Round. This is also true of job candidates as Tim Chen, founder of Nerdwallet says in a Forbes  article:

What’s a good reason to raise money? Tim says the problem was that even though they didn’t need the money, great talent wants social validation. They want to know who your investors are. So, they raised a big round.

Timing: I was taught by a VC that the best time to raise money is when you don’t need it (but will at some point in the future). By raising money when you don’t need it you have much more leverage with investors. You will reduce the stress and strain of raising money when you do need it. Believe me, investors can smell desperation!

Time: without pressure of needing more  capital you can take your time building  your pitch deck, and very importantly, practicing your pitch.  You also have more time to find prospective investors who are a good match for your venture.

Flexibility: Though you need to outline a “use of proceeds” in your pitch to investors, since you don’t need the money immediately you will have the option of changing how you spend (invest) that money in the future.

Competition: Competition amongst VCs does two important things for founders: one it generates FOMO – Fear of Missing Out – driving a sense of urgency; and two, competition drives valuation. Since you aren’t in immediate need of capital you will have the time to to perform proper due diligence on your investors and to garner more than one term sheet.

More resources: with more capital in hand you can hire more staff, spend more on customer acquisition, and make other important investments in  your venture.

Creating value: the longer you wait to raise money the higher your valuation should be, which translates into getting more capital for the same amount of  equity – leverage. And you are focused on these two things: your customers and creating value in your venture, right?

Access to investor’s value: investors don’t just provide capital. The best can help you recruit for your management team; provide good advice, feedback and guidance on your strategy; and provide helpful contacts of all sorts.  Value-added is one way VCs compete for the best deals.

Of course, there are downsides to raising venture capital. Food for a following blog post.

 

Some less than usual VC questions you may need to answer

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No doubt that most readers of this blog, if not this blog post, have seen at least one list of the important elements you need to communicate to an investor. But Jeff Schumacher, founder of BDG Digital Ventures, has a few that I don’t often see in pitch decks in his Entrepreneur.com article How to Become Investable in 13 Steps sub-titled If you want investors to take you seriously, you need to know the answers to these questions. You don’t necessarily need to include these in your deck but be prepared to respond to each and every one.

3. Why now?

Too many founders just assume that now is the right time for their venture because now is when they started up. There are two precursors for a timely startup: the availability of enabling infrastructure at low cost, like Amazon’s AWS, and market readiness, for example the market doesn’t seem quite ready for crypto currency in my estimation.

4. Corporate alignment

What Jeff calls corporate alignment I call partnerships or M & A. How can being aligned with a large company benefit the startup? After Course Technology was acquired by Thomson we were given access to their Canadian field sales force which enabled our Canadian sales at much lower cost to us than building our own Canadian salesforce would have cost. You do have to be careful about how aligning with a corporate partner will look to other players in the market; it may drive away other prospective partners if you get in bed with one dominant corporation.

11. Ecosystem

I recommend to my mentees that they diagram the ecosystem for their product: prospective customers, competitors, vendors, investors, analysts and other stakeholders. This is especially necessary in the case of startups that aim to become platforms. What elements of the ecosystem will join your platform and why?

13. Road map

As founders you need to plan where you want to be in the next 12 months, the next 18 months and the next three years (beyond that is in the realm of fantasy, not planning). You also need to know what resources you will require on your roadmap and how you will acquire them (raising capital, customer revenue, debt, etc.) Keep in mind the revenues tend to lag expenditures, often by weeks if not months.

As I’ve said before, I applaud the efforts of VCs to educate founders through their blogs, books, and presentations at conference. What was an opaque business to us when we started our first company in 1989 has become much more transparent, with the help of sites like TechCrunch and Pitchfork as well as VCs like Jeff Schumacher.

Does every startup need VC capital?

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Virtually every startup I mentor at MIT seems to believe that they need to raise outside capital immediately. While there are few notable exceptions, it seems like the entrepreneurial culture puts a premium on raising venture capital – it’s sort of the startup seal of approval. But Peter Strack argues against the tide in his Forbes article Why You Shouldn’t Always Raise Money For A New Business. Here are his arguments annotated by my comments:

You Can Keep 100% Of Your Company

As a notable VC once reminded me, “They only make 100% of the company, so act accordingly.” But there’s a more important factor than how much equity you have upon a liquidity event, that factor is control. Once you take a VC investment you will be giving up a board seat to that investor. Since first rounds are often syndicated, there may be two or more VCs looking for board seats as well. Generally you can get two insiders on your Board, the founder and another member of senior management, to balance the two VCs, but you aren’t going to have the freedom and independence you had as a new founder. Keep in mind that you may be working with these investors for years, so make sure the individual partner and their fund are going to contribute more than money – contacts, advice, feedback, and support when times are tough.

Bigger Is Not Necessarily Better

While tech startups often need engineers to build their product and these engineers typically will want a salary, which can increase the pressure on the founder to raise money. But keep in mind Mr. Strack’s admonition: Premature scaling can cause technology startups to fail. And 46% of professional, scientific and technical services companies close within the first five years.

You Learn So Much From Doing It Yourself

I consider learning to be job one for any founder. No matter what your academic credentials, not matter what hot startups you’ve worked at, being the CEO of a startup is very hard. The longer you can stay in control and learn the ins and outs of running your company the more you will learn, and the more valuable the company will be. Of course, there is a point of diminishing returns where you will need to bring on partners and staff but premature hiring is almost as dangerous as premature scaling, actually it’s a subset of that problem.

So what does Mr. Strack advise in lieu of taking on investor capital?

• Hustle – hard work is just the ante. To create value in your enterprise you need to be productive. That means being absolutely ruthless on how you spend your time, your most valuable asset as a founder. Focus on productivity not activity.

• Be smart with the funds you have – I was taught by the VCs to stretch the dollar. For example, rather than hiring full time staff who require not only salaries, but benefits and stock options as well, use consultants and contractors to work on a project basis.

And let me add one other point: look for leverage. As Archimedes said, “Give me a lever long enough and a fulcrum on which to place it, and I shall move the world.” Examples of leverage include hiring interns instead of consultants and contractors, finding a law firm that will defer your fees until your first round of investment, and sub-letting office space from another tech company that may have a surplus and be willing to offer you a cut rate.

There is nothing wrong with raising capital, but be strategic about it. The best time to raise capital is when you don’t need it. Believe me, investors can smell desperation a mile away and they will take advantage of it. And keep in mind it can take six months or more between starting to raise capital and the check clearing the bank. So start understanding the VC climate in your region. Get to know some VCs informally. But just because you are studying something doesn’t mean you are committed to it. The Boy Scouts’ motto applies to raising capital: Be prepared.

How to raise your first round of capital

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If you are looking for great information about startups in an easily digested format, e.g. slides, I highly recommend Slideshare.net.

One major change in VCs in the past decade or so, which I believe was spearheaded by Brad Feld of The Foundry Group and Fred Wilson of Union Square Ventures, has been a sincere attempt to educate entrepreneurs. While I’ve known both of them I never asked them about their motivation, but I can take a good guess. Top flight VC firms see literally hundreds of pitches a year, year in, year out. Yet a partner like Brad or Fred may make only one or two investments per year. So it is in their interest to teach entrepreneurs not only how what VCs want to see in a pitch, but how to conduct themselves in a VC meeting, as it is much more efficient to deal with educated founders rather than having to teach everyone, one at a time.

I’ve already written about and recommended Brad’s book, Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist. Now I’m going to recommend a great slide presentation by Jeff Bussgang of Flybridge Ventures entitled Mastering the VC Game: How to Raise Your First Round of Capital. It’s a 19 slide primer that takes the founder from first pitch to due diligence. While its six years old I don’t think anything has really changed in the VC game regarding how to raise your first round of capital. Of course Jeff being a VC he doesn’t spend any time educating founders about the alternatives to VC funding, such as corporate VC, angel groups, angels, super angels or grants like SBIR. After you’ve gone through Jeff’s presentation check out my blog post VC funding and its alternatives to help decide what type of investor is the best fit for your venture.

I have to admit I have not yet read Jeff’s book, Mastering the VC Game, but based on his blue chip reputation and the quality of his slide presentations (you can search SlideShare for others), I’d venture to say it’s well worth reading.

If you still have questions and the time to search for answers there are a number of posts on this blog that fill in the many gaps in knowledge of raising capital that I’ve seen from mentoring dozens of founders in the past decade.

Lessons learned by a successful serial entrepreneur

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I’m going to excise the important lessons learned from the Forbes article 300 Investor Rejections And 1 Failed Startup Led This Entrepreneur To Build A $1 Billion Business by 

Here are his lessons learned along the way, which I heartedly endorse, both from my own personal experience as well as experience mentoring dozens of founders:

Three Essential to-do’s

  1. Surrounding himself with good product engineers
  2. Really getting a handle on product market fit
  3. Learning how to talk to investors

If he was to ever start again:

… he would spend a lot more time thinking about and vetting an idea before jumping into it. Spend a lot of time talking to customers or potential customers, and also talking to investors, and really starting to define and refine the business model, the customer acquisition strategy, the business model, the defensibility, the network effect.

Raising capital

  • He had to go from fundraising in California to New York where investors got it
  • He learned the secret isn’t convincing investors, it is finding the investors that love the idea
  • Learn to leverage a lead investor who will syndicate the deal to others
  • Learning some sales skills

Ward had about 300 turndowns from investors for his two startups! But his second point is perhaps the most important lesson learned about raising capital: it’s all about investor-venture fit. Founders tend to think that by getting more meetings, sending more emails, making more phone calls – whatever, more is better – they can convince an investor to fund them. No! If you don’t get resonance from the first two meetings move on! Take that energy and your precious time and dig for a well elsewhere, digging deeper and deeper won’t strike oil! Of course, this assumes you have heeded Ward’s start again tip to talk with investors before you jump into a venture. You have studied their portfolio and talked to some founders they have invested in – performed your due diligence on prospective investors.