Reconsidering Post Money SAFEs

If you’re a NYC startup contemplating a seed round, you’re probably considering one of a handful of structures: convertible notes, SAFEs, or equity.

For smaller seed rounds, it’s hard to choose equity.

For rounds below $1-1.5MM, convertible securities (either notes or SAFEs) are the favored approach because of their simplicity and speed.  It’s possible to do equity rounds for any amount, and there are seed-stage equity-focused open-source documents that make the process simpler.  But it’s usually the case that the time costs and transaction costs for smaller seed equity rounds are roughly in line with the transaction costs for larger seed equity rounds, and thus the costs end up feeling relatively high.  Most startups can go from handshake to closing and wiring far faster, and at lower cost, with a convertible note or a SAFE, relative to equity.

The SAFE

While in Silicon Valley the “Simple Agreement for Future Equity” (SAFE, created by Y Combinator) has become a dominant standard for seed rounds, that is far less the case in almost every other market. SV is a unique place in terms of the concentration and competition of capital, and the fundraising culture there tends to operate by its own rules. SAFEs do get used on the east coast, including NYC, but they aren’t anything close to the standard.

Enter the Post-Money SAFE

Recently, YC completely overhauled the SAFE instrument, having it now convert on a post-money instead of pre-money basis. It is very hard to overstate just how dramatically this affects the conversion economics of SAFEs. Most importantly, the new post-money SAFE has a level of investor-friendly anti-dilution built into it that should give seed stage startup founders significant pause.

Under the post-money SAFE, you are penalized if your next round (after the SAFE issuance) isn’t an equity round that converts the SAFE, because the SAFE holders are protected from all of that dilution until conversion. This is the case even if the valuation in the next round is higher than before. Most anti-dilution protection only kicks in when there’s a down round, but with the way the new SAFE works, your SAFE holders have anti-dilution even in an up-round scenario in any context that the new round isn’t equity.

This new SAFE structure is more aggressive, and investor favorable, than any other kind of anti-dilution built into conventional seed instruments.  YC says their reason for designing the new SAFE this way is to make it easier for companies and investors to model SAFE conversion in a spreadsheet. And, yes, it’s easier to model the post-money SAFE conversion.  The reality is that if the modeling was the only motivation, there are other ways they could’ve made SAFEs easier to model without pushing the economics to be so far in investors’ favor.  

From too company friendly to too investor friendly

One reason SAFEs never took off as much outside of Silicon Valley is that the original pre-money SAFE was seen as far too company friendly, and investor unfriendly. And speaking as startup lawyers who don’t represent a single tech VC, we actually agree that pre-money SAFEs were an imbalanced instrument lacking in even basic, reasonable protections for investors.  It was a great instrument for a company that could find investors to fund pre-money SAFEs.  But the new Post-Money SAFE is, given its unique economics, a sub-optimal correction with its own set of problems.

Consider Convertible Notes…

Companies should strongly consider convertible notes for rounds below $1-1.5MM.  We talk with companies all the time about their key concerns about convertible notes: interest rates and maturity dates.  And most of the time, those concerns can be easily addressed, and the worst results of the concerns (such as investors demanding repayment at maturity) never come to fruition.  The reality in the marketplace is that most of the time, the interest rates are relatively low.  At the times that convertible notes actually convert in equity rounds, we rarely hear founders upset about the impact of the accrued interest.  And most convertible note financings done in as a part of a seed round have relatively lengthy maturity dates of at least two years.  (Maturity dates are often shorter for true bridge rounds, such as between a Series A and a Series B.) 

…or Equity

For larger seed rounds, equity is the more balanced alternative to the post-money SAFE.  And, as always, circumstances vary and should be discussed with experienced counsel knowledgeable about local market conditions.

For a deep dive on problems with the post-money SAFE, see: Why Startups Shouldn’t Use YC’s Post-Money SAFE.

By Jeremy Raphael

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