Why SAFEs Can be Confusing

• 6.5.2017

NOTE: This article originally appeared on Inc.com on May 22, 2017.

Entrepreneurs often raise capital with a combination of convertible notes and an agreement called a SAFE, or Simple Agreement for Future Equity. A SAFE seems like a no-nonsense DIY solution for early-stage companies—but there's more you need to know about them than you might realize.

Debuted in 2013 by Y Combinator, the SAFE doesn't accrue interest. It has no maturity date or expiration date. It converts into equity on pre-negotiated terms in connection with a future priced equity round.

Convertible notes, which were the norm before SAFEs came along, are agreements to eventually convert an investment to a stake in the company. They have maturity dates and bear interest. Convertible notes and SAFEs are quick, painless ways to raise money because their terms are relatively fixed. They're fairly straightforward resources for early-stage entrepreneurs—until they aren't.

Founders run into problems when they secure capital from seed investors who insist on tweaking the language in the financing standard documents. Some investors specify that conversion occurs on a pre-money basis. Others prefer a post-money basis. Some include any new option pool in the conversions terms. Others don't. Some provide for a discount or a capped valuation on conversion, while others have just a cap.

These altered documents do, however, have something in common: None contemplate how they will interact at conversion. Sorting that out is a costly and time-consuming process that will ultimately require every investor's approval.

Divvying up the Leftovers

When VCs look to invest, they negotiate a percentage of the startup they'll acquire in exchange for their capital. What they own is clear. But their investment forces earlier backers to divvy up whatever's left. If the terms haven't spelled out who has priority and how the conversion will proceed, those investors can't determine what they hold and where they stand. Disagreements are inevitable.

SAFEs never contemplated this common situation. Each exists in a vacuum as a single convertible instrument. But investors and companies don't operate that way. Startups often need multiple rounds of seed funding to get off the ground. The SAFE, however, is a generalized, static document pressed into service for a fluid situation.

Founders are usually surprised to discover that having multiple SAFE investors leaves them with less equity than they expected. They don't like this, and neither do VCs. The investors want the founders to stick around to run and grow the business, but it's hard to incentivize them when the founders have already cut themselves a smaller piece of the pie.

Best Practices

A discordant stack of SAFEs and convertible notes complicates the process of accepting a significant new investment. I'm not, however, advising founders to swear off SAFEs for seed funding. But they can reduce the likelihood of problems—the kind that require a lawyer to fix—by adhering to these best practices:

Have a plan. Develop a strategy for raising money—not just this week or this month but for the next several years—and review the documents you're asking angels and seed-round funders to sign.

Don't go it alone. Understand how each new round of funding you accept will alter your equity position in subsequent rounds. A one-hour consult with your attorney before you pocket the money can save you 50 hours of legal fees, plus delays, angst and aggravation.

Lather, rinse, repeat. For consistency's sake, use the same SAFE or financing documents every time you take seed money, subject only to valuation changes.

Know your limits. How much of your stake are you and your co-founders willing to cede? Decide where you draw the line so you don't lose precious equity and control.