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Are SAFE notes safe for investors (or founders)?

August 26, 2022
Written by Dougal Cameron

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We believe that SAFE notes are bad for investors, founders, and the startup ecosystem. They are designed for early-stage venture funds to simplify the investment process and sideline the super-early-stage angels and friends and family that so often help get companies started.

SAFE notes are not notes and they aren’t ‘safe’

The name implies peace and happiness. But that’s not what your investor will think when they receive their separate share class stripped of its rights and privileges. The investor taking the risk on your company is exchanging cash for a promise to get in at a discount to a professional venture fund investment, often subject to a cap. However, what if this doesn’t happen? Or what if it takes a decade? SAFE notes usually don’t have an interest rate or a maturity. The lack of these features is irrelevant in a fast-paced ecosystem where a funding round could occur every 8 to 10 months. In a slower pace though, the promise of future equity can degrade in value simply because of time.

The term ‘note’ implies some sort of security. However, most SAFE notes are explicitly unsecured. Founders have great latitude to use the capital of the firm anyway they choose even if it means no recovery for the SAFE investor. This latitude is not equivalent to a traditional convertible note which often have some form of restrictive covenants to give the founder operating latitude but with safe boundaries. This means that the optimism that drives so much entrepreneurial grit can also result in an entrepreneur using up all the company resources rendering a total loss to the investor.

SAFE notes expose founders to potential expectation problems

All people have expectations and investors are no different. Put yourself in your investor’s shoes. Early-stage angels and micro funds are betting on you to deliver a 10x – 20x return potential. Often, they expect to be treated similarly to later-stage investors and have a ‘seat at the table’.

These expectations are at odds with the true purpose of a SAFE instrument: greasing the wheels of an institution coming in on a future round. Institutions don’t like drama. We especially don’t like drama when it comes from exogenous sources to the company. I acknowledge the value that a SAFE note delivers to an institution like mine, but the value is at the direct cost of the investors who took the early risk.

Worse yet… for founders this means a bad experience for the investors who showed you the most trust. These investors took a risk on you when the institutions would not take the same risk and now, once the SAFE converts, the institution gets the protection and the pro rata rights while the angel gets a junior share class. Worst case scenario this could result in the institution making a return on capital while the angels don’t.

A word on convertible notes and priced rounds

Like everything else, a company has a value. And this value isn’t determined by the hive mind at different media platforms. Instead, it is determined by millions of transactions that collectively price risk in our society. One of the more difficult elements of the founder experience is determining a fair price for their company. It is a journey.

The journey begins with an understanding of the risk presented and ends with compensation for that risk for the investor versus other allocation options for their capital. So, what is the right price for a company with no revenue?

Ultimately the answer is in what people will pay you. The problem here is that ‘people’ can include those who love you or are in love with your grit, energy, business, or vision. This love distorts their pricing mechanism and results in distorted decision-making data.

At Golden Section, we believe priced rounds are the most honest way to arrive at a price that will keep all parties aligned. In some circumstances, a convertible note with a sensible cap that roughly equates to the price of the company at present adjusted for the interest effect is preferred. The typical reasons for a convertible note vs a priced round surround the legal cost efficiency as well as a circumstance that can cause a large bid/ask spread like pending contracts.

Choosing a convertible note instead of a SAFE note

Unlike a SAFE note, a convertible note, in most cases, gives the investor similar (and in some cases, the same) rights as the institution coming in at later stage. This can mean more friction for the founder as they negotiate with the institution, but this friction is what the founder signed up for when they accepted capital from friends and family. Better yet, a convertible note is more honest.

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