The SAFE Nightmare
Updated: Oct 4, 2022
When you buy or sell something, you want to agree on a price, don’t you? It is probably the most essential variable for your final purchase or sales decision. It would just be crazy, for a buyer of a house, for example, to say, ‘hey, why don’t I give you some money now so I know that I own a piece of your house and we see what exact price I pay for this piece and how big it is later on when somebody else invests...’ Well, this is exactly what the popular Safes (and to a lesser extent convertible loans) are. And we are seeing more and more of them recently... While interesting for smaller investment amounts early on or smaller bridge rounds, they can quickly mess up the cap table of a young company and turn into an absolute nightmare for founders if not careful.
I am not a big supporter of Safes and convertible notes; on the contrary. I recently met several founders of exciting young companies who struggled with them. They created a massive headache to make a proper equity round happen. So, I decided to share how and when they should be used. And why they are usually not such a great idea... Disclaimer: We have done them in the past and are not strictly opposed. But founders need to know what they are up against. Hopefully, I can convince you to avoid them 😉 So, here we go…
First, what are Safes or Convertible Loans, and what’s the difference?
Safes, unlike convertible loans, are not a debt. Safe stands for ‘Simple agreement for future equity.’ It became popular about 10 years ago. It represents a simple way for startups to raise capital without encumbering their balance sheets with debt. Terms are generally also less onerous than you would find in convertible debt instruments. Safes don’t give companies a free ride, but where there is no debt, there can be no security and, generally, no repayment on a defined maturity date. There will usually just be a discount on a future funding round, and sometimes, but not always, a cap on a next equity conversion valuation. What both have in common though is the underlying intention that the amounts invested will be converted into the next qualifying financing round…
Convertible loans, on the other hand, usually demand on top repayment of the loan or automatic conversion at a defined price (these usually have a cap and sometimes a floor) at a specific maturity date (if there is no qualified financing round).
Are Safes a good or lousy instrument to raise capital?
They are really bad for raising relevant financing rounds, especially if they exceed an investment amount of EUR 1M-2M. Here is why:
As with the example I gave in the intro, there is just No Price. As a result, they defer the most critical investment terms, valuation and founder dilution, to a later stage. I think this is insane. Founders should know precisely how much of their company they own at every moment of their journey. Price is always a tricky topic, and Safes just avoid it by merely kicking the can down the road... Good investors will also have an idea of how to price your business and can articulate their rationale. More petite angels, friends, or family rounds are different. They are often done via convertible debt. It makes sense that they would not want to enter into a tough negotiation with a founder and would prefer to let the price discussion happen when professional investors enter the equation.
Avoiding the price discussion makes things so easy at first that you can get addicted to Safes (as my colleague Michael put it) and raise a couple of them (sometimes with different terms!) on top of each other… This goes on until (inevitably!) a priced round actually happens. Then Safes start crashing into each other simultaneously, just like a house of cards, making a clean round nearly impossible. And the biggest losers out of all of this are usually the founders. Doing more than one Safe or raising more than EUR 1M-2M in Safes is almost always a problem in the making… and many people around the table will be pissed off. Without clarity on price, Safes can put founders in tricky positions. Often they indirectly promise investors a potential amount of ownership, for example. Some months later, though, they sometimes cannot deliver on this promise when the notes convert. By the same token, founders tend to think the Safe cap should be the minimum valuation of a next round and will be disappointed when they realize it was unrealistic. For example, many founders who raised Safes last year now have to see their valuation drop much lower than expected… if the size of these Safe(s) is too big, we have a serious founder dilution issue now.
I hope you can now see why Safes are not the best financing option for founders or investors. I recommend everyone to do priced equity rounds. It doesn’t take much longer and the legal costs are also acceptable nowadays, especially early on. If you or your investors want to invest via Safe(s) nevertheless, make sure you don’t raise more than EUR 1M-2M in Safes until the next financing round. Be transparent with your investors and yourself on future cap table scenarios post conversion in a next fundraising round. With markets calming down, I guess we will see fewer Safes in the next 24 months, particularly those with no warrants and/or valuation caps...
When does it make sense to use these instruments?
Convertible loans are a great tool for companies to extend their runway. I see more of this happening now as the fundraising market got tougher. These loans are usually called 'bridge' loans and are intended to be a bridge to something else, usually a new financing round with new outside investors. They could also be a bridge to allow the company to get cash flow positive or a sale of the company. A bridge is a good idea if everyone around the table, you and your investors, are confident that this new event will happen. However, if none of these scenarios occur in a relatively short period (e.g. 10-18months), then the bridge becomes a bridge to nowhere... And a bridge to another bridge usually doesn’t end well and should be avoided. Hope is never a good strategy...
Your lead investor should step up when it is time for a bridge. This is typically the investor with the largest capital invested and/or largest ownership. He should suggest terms, and work with the investor syndicate to come together and provide a bridge loan. That kind of leadership is crucial, especially when fundraising gets harder. The startups with strong leads will do a lot better in tough times, and this is an excellent example of why that is…
The alternative to a bridge is a priced round with your existing investors. This is a real round of financing and not a bridge loan. While that can sometimes be the correct answer for a startup (especially if it is not yet clear if the company’s next milestones will occur in the short term), it is usually preferred to bring new investors into a company of course. They can price the business objectively, strengthen the cap table, bring new ideas and experiences, and just make the company more resilient... Let’s have a look at an example. Let’s say your company really wants to bring new investors into the business with another round, but it is taking longer. But you and your investors are confident that it will happen. A bridge is interesting in this case. How would this look like:
All the insiders/relevant investors should participate, ideally ‘pro-rata’ and perhaps weighted a bit towards the 'bigger' investors in terms of AuM. If some investors with relevant ownership are unable to or do not want to participate, then it gets tricky. Nobody likes to take on the risk of somebody else. This usually does not end well for these (blocked or blocking) investors, and you will have to push a deal through, even if it hurts them.
The structure of a convertible is usually a discount upon conversion into the next round of financing with a nominal interest. Discounts usually range anywhere between 5%-25% depending on the size of the loan and the expected timing to a next financing event. Sometimes discount rates are staggered based on the amount of time the loan is outstanding. The longer it takes, the higher the discount. The idea here is to create an incentive to get the round done quickly, of course.
An important ‘detail’ to consider is if the loans convert into the next round (added to the investment amount of the new investor(s) coming in, which makes the round bigger and gives the new investors lower ownership) or before the next round (converts before the actual financing round by the new investors. This is usually cleaner, especially if the size of the convertible loan is relevant compared to the size of the new funding round).
What happens if the company is sold when the loan is still outstanding? If nothing is specified, the lenders will only get their money back, plus interest, in a sale. That is not really appropriate, given the risk they are taking. Therefore a premium usually has to be paid in the event of a sale, something between 2x and 3x.
Last weekend, we got ready for our annual family 'apple harvest' tradition. 2022 will be a great vintage mix. Apples are like grapes. While apples have been less and smaller than usual due to the high temperatures this year, the vast amount of sun made them especially tasty...
Life is awesome
Other content I found useful
- The Belgian newspaper L'Echo launched Yaka. This is a great initiative that I am very happy to support and be involved with. The ambition is to organize several smaller events regrouping key players in the Belgian tech ecosystem to foster the local ecosystem. Yaka!
- A cool thread on 'How much founders should be paying themselves' by the Loom founder
- Check out the latest report on 'Consumer Subscription Software 2022 - The Evolution of CSS'
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