It’s the best vehicle for investing in early-stage startups
Last week I had the opportunity to speak about why I think the post-money SAFE is the best investment vehicle for early-stage start-ups, better than convertible notes.
While I was preparing my presentation, by some weird cosmic coincidence, I had not one but three startups pitch me on investing using the old pre-money SAFE that investors hate. It made my head explode.
I thought the old pre-money SAFE was dead and buried, but it seems to be making a comeback. Unfortunately, this resurgence is highlighting the horrors of the pre-money SAFE and eclipsing the greatness of the post-money SAFE.
Meanwhile, skittish investors are continuing to just say no to SAFEs without considering the critical difference between the two versions.
So I’d like to explain why investors should love the post-money SAFE and why startups should avoid the pre-money SAFE if they want to attract investors. The reasons are in the details, so if you don’t want the tl;dr, here’s the executive summary:
- Startups: The pre-money SAFE was deprecated in 2018 because investors hated it. We hate it even more now. It’s a non-starter. If you want investment, don’t use it.
- Investors: The pre-money SAFE sucked. It’s gone. The new post-money SAFE is better than convertible notes. Get over your instinctive dread of the SAFE and welcome the post-money SAFE as the best way to invest in startups.
The options to invest in a startup are:
- Common stock
- Preferred stock
- Convertible note
Common stock is for founders and employees. For investors, they’re a non-starter. Investors require preferred shares with protections that prevent the founder from unilaterally wiping out our investment.
Preferred shares are ideal, but there’s a lot of terms and paperwork which takes time and money. Unless you’re raising at least $2M, preferred shares rarely make sense to issue.
For smaller raises, we need something lightweight. We need a placeholder that allows us to invest now and get preferred shares when they’re issued later.
There’s 2 choices: convertible notes and SAFEs. Though the goals are the same, they’re very different vehicles. Which one is used has huge implications for both the startups and investors.
Historically, investors have preferred convertible notes for their flexibility and protections. Startups and accelerators have preferred SAFEs for their simplicity.
The convertible note is legally a loan that includes an option to convert the principal and interest to preferred stock once it’s issued.
Because it’s a loan, the convertible note includes a maturity date, usually 18–24 months, along with an interest rate. The conversion option lists the agreed pre-money valuation and discount for the preferred shares.
The maturity date creates a deadline by which the startup has to raise a priced round of funding and issue the preferred shares. If the company reaches the maturity date without raising a priced round, whether the loan has to be repaid or it automatically converts to preferred shares is just one of the critical details that has to be negotiated between the startup and lead investor.
While far simpler than preferred equity, considerable time and cost is still required to negotiate the terms of the convertible note.
For investors, there’s another important consideration. As a debt investment, convertible notes don’t qualify for the incredible Sections 1202 and 1244 tax breaks for investing in startups until the debt is converted into equity.
Convertible notes add an extra 18–24 months to the 5 years we have to hold equity before qualifying for tax-free gains. And if the company fails before reaching the next round, we don’t get the benefit of writing off our losses against income instead of capital gains.
More importantly, convertible notes almost always use a pre-money valuation cap.
(More details here.)
The price I pay for the shares, when they’re eventually issued, is based on the post-money valuation, so that’s the only number that matters.
To get from a pre-money valuations to the post-money valuation seems deceptively simple:
pre-money valuation + investment = post-money valuation
If investors put in $2M at a $5M pre-money valuation, the post-money valuation is $7M, right?
Maybe. Maybe not.
If the company raised a previous round on SAFEs or convertible notes, that amount has to be included, too.
If there was an earlier $1M round, plus the current $2M round, the post-money valuation is $5M + $2M + 1M = $8M. Right?
Maybe. Maybe not.
This is all the current and prior investment at the time I’m investing, so that’s all I can know.
The company promises their next round will be a priced round, so I assume my post-money valuation will be $8M.
But…their path to market takes longer than expected, so they have to raise a bridge round to reach the milestones for a priced round. Fortunately, a strategic investor offers to put in $4M on a convertible note.
My post-money valuation has just increased to $12M.
Not great, but not horrible either.
A year later, they’re generating sales and ready for that priced round. But…they can’t find a lead investor. However, they do find 4 small funds willing to invest $2M each on convertible notes. The founders have no reason not to accept that investment.
Ugh. My post-money valuation just went to $20M.
I stupidly thought I was investing at a $5M valuation, but it was really $8M at the time, which turned out to be $20M by the time I was issued shares. If I’d known the valuation would be $20M, I wouldn’t have invested.
This post-money inflation occurs regularly. While usually not this extreme, it’s not uncommon for a pre-money $5M valuation to turn into a $10M or $12M post-money investment. Which would be fine if I knew the valuation I was investing in, but I don’t.
With a convertible note, at least there’s a maturity date. This limits the number and size of any fundraising prior to the priced round as well as starting the clock on the tax breaks. I want that maturity to be as short as possible.
But with a pre-money SAFE, though, there’s not even a maturity date. I have no idea when I’ll receive my shares and at what valuation.
Y-Combinator is the biggest, baddest startup accelerator in town. Their most recent cohort includes 319 startups.
When you’re dealing with hundreds of startups at a time, you don’t have time to negotiate individual investment agreements.
Most of the startups in the YC accelerator are very early stage, some even still in ideation. They may be 5 years away from issuing preferred equity in a Series A priced round. The convertible note, with a maturity date and compounding interest, wasn’t a good fit for YC’s investment. So in 2013, YC created the SAFE — Simple Agreement for Future Equity.
Think of the SAFE as a kind of receipt for pre-payment of equity — I give you $1M now, you agree to give me $1M worth of preferred shares as soon as you issue them. We fill in the template with our names, purchase amount, and valuation cap, then sign the document and wire the money. No lawyers, no negotiating. It couldn’t be simpler.
The first version of the SAFE used the same pre-money valuation as a convertible note. However, unlike convertible notes, there was no maturity date. Preferred shares might not be issued until years later.
That was fine for accelerators and great for startups, too. It was even okay for friends and family investments which are more like donations that financial investments.
But experienced angels and angel groups gagged. They hated it. A pre-money valuation with no maturity, no interest, no board representation, and no voting rights was an automatic no.
YC heard the complaints. And in 2018, they released an updated version called SAFE v1.1 and known as the post-money SAFE.
With the post-money valuation, I know how much I’m paying for my investment.
Further, the updated SAFE added text to attempt to ensure that for tax purposes, this investment is considered purchase of equity. While the IRS hasn’t ruled on the matter so there’s no guarantee, most investors are assuming that v1.1 meets the requirements of an equity investment and immediately starts the clock on the 5 year holding requirement.
Between the post-money valuation and the likely qualification for tax benefits, the updated SAFE seems like the best investment vehicle for early-stage investing, better than a convertible note.
While there is no maturity to force the issuance of preferred equity, with a post-money valuation and immediate tax qualification, the timing for issuing preferred shares no longer matters.
YC provides 3 separate templates for the SAFE:
- Post-money valuation cap
- Discount only
- Most-favored nation
The post-money valuation cap version is great. The discount-only version is a complete and total non-starter, the same problem as the pre-money SAFE only a million times worse. The MFN version isn’t much better, but can be useful for accelerators or strategic investors willing to accept whatever terms get agreed with other investors in the round.
(More details here.)
Given the choice between a post-money SAFE and a convertible note, I prefer the SAFE. I’ve locked in the valuation and don’t need to worry about getting burned by the conversion. And I can take advantage of the incredible tax breaks, at least unless the IRS says otherwise.
Still, there are some advantages of a convertible note, especially for larger investors. It has more flexibility for negotiating terms, and it does create a deadline for issuing preferred shares that include voting rights and other protections that a large investor wants. So don’t be surprised if some VCs and angel investment groups insist on using a convertible note.
However, it’s also possible to negotiate any key terms such as pro-rata rights, information rights, board seats, etc. and included them in a side letter with a SAFE.