For a Lower Investment Return – Agree to a Covetable Note or SAFE Structure.

For a Lower Investment Return – Agree to a Covetable Note or SAFE Structure.

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To say I am not a fan of Convertible Notes or SAFE as a form of investment would be somewhat of an understatement. The big reasons I see for Convertible Notes being so damaging is that Angels using Notes rarely get their agreed terms of conversion.

One of the most common cram downs on Angels with Notes is the class of shares they end up with (as opposed to, were promised). The Angels enter a note with a 20% discount (what experienced Angel thinks 20% valuation growth in 6-12 months is anywhere close to adequate?) and a promise that their Note will convert into the same class of shares as issued at the next round. The VC round (or pretty much any other investor) at the next round says “No way!”, they can’t have my preference shares, let them convert into ordinary, or at best, a preference behind the new investor. So now the ridiculously low discount rate, the probably over generous (high) cap and the failure to achieve preferential terms means the Angels with Notes are not even getting basic dilution protection on the round.

Of course, the Angels would not normally agree to such abuse but, as a Noteholder they are not at the negotiating table for the new round (the Note does not give them the full investor protections typical in a priced round). Ultimately, they are presented with a ‘take it and get f*$ked’ deal. It is not uncommon for other terms of the Note to be abrogated too.

Fortunately, I live, and largely invest only in a geography (the UK) where Convertible notes and SAFE are effectively unknown (and given that the UK is the largest Angel market in Europe, that in itself points to the fact that neither are necessary to ensure companies get funding!).

The use of both Convertible Notes and SAFE has emerged from the USA, and initially largely the West Coast. In practice SAFE’s are not used nearly as frequently as they are talked about by early stage entrepreneurs. They are a minor part of early-stage investing, account for just 4.7% of seed deals in the USA[1]. SAFE’s account for about 10% of seed deals in California – influenced by Californian Incubators. Elsewhere investors are less enthusiastic. A recent post by Launchpad Venture Group described them as “a cancer of the investing world[2].

Convertible Notes are more common, accounting for up to 50% of seed deals in the USA[3] (for series A deals, just 12% were Convertibles). So definitely used – but as many commentors suggest, not necessarily the preferred choice of many investors. See https://www.rockiesventureclub.org/frontpage-article/ten-reasons-not-to-use-convertible-notes/  for 10 reasons not to use Convertible Notes.

And now for reason 11 – if you use Convertible Notes your investment returns will suffer. Launchpad Venture Group looked at 484 individual investment rounds that the group has made using Total Value to Paid-in-Capital (TVPI) return multiples. This metric measures the current value of the investment (both realized and unrealized) as a multiple of the cash invested.  They found that their returns were significantly lower when investing in Convertible Notes (1.1x) and SAFEs (1x) in comparison to Equity (2.2x)[4].

The Launchpad TVPI multiple on convertible notes and SAFEs is half what it is for preferred equity, and this difference is sustained over 258 rounds of equity investment and 188 rounds of investments in convertible notes. 

Digging Deeper – Why are Convertible producing such a poor relative return?

  1. Positive Exit – For 5% of note rounds, this was the last round of financing and the company successfully exited without needing to raise additional funding. This is a best-case scenario where notes were used as a bridge to an exit, and the investors received a 1.55x return on their investment. A positive return, but lower than the average equity returns of 2.2x because noteholders only receive the benefit of their discount or cap at the time of exit rather than benefiting from any growth of equity value.
  2. Note Converted to Equity – 35% of Convertible Notes behaved the way they are supposed to and converted into equity at the next fundraising round. The average returns of 1.3x in this outcome reflect the note discount or cap, but are below average equity returns. This highlights the likelihood that the majority of discounts are set too low (25% is just not enough), or the caps too high (eye off the ball, allowing too high valuations).
  3. Not Yet Raised Another Round – 11% of the rounds were recent enough that the company hasn’t yet raised another round of financing, but the company is still active. These notes are being carried at their original face value of 1x investment.
  4. Company Failed – 4% of the note rounds were the last investment before a company failed, and they returned nothing.
  5. Raised Another Note Round – This may be the area of significant issue for Angel investors – 44% of note rounds were subsequently followed by yet another note round. Serial-note rounds kill investor returns by delaying a conversion to equity and hence delaying the point at which the investors benefit from real company value growth. Investors are effectively receiving debt-level returns for equity-level risk taking. Many companies that raise capital through a succession of note rounds (often motivated by fear of dilution – possibly driven by lack of value creation?) remain under-funded and continue to struggle to hit real value inflection points. In many cases investor controls within the Note are limited to non-existent, so the investors have no say in how many notes are issued in the future.  For such companies, the Launchpad returns were just 0.84x.

It’s hard to achieve positive returns as an Angel Investor. Do you really need the added drag of a Convertible Note or SAFE structure?


[1]The 2019 HALO report found that SAFEs were most frequently used in Mid-Atlantic Region at 12%, likely heavily influenced by US Federal DOE, NSF, NIH, and other grant money which does not permit debt as a liability while grant funds are in use, hence early stage companies who do not wish to price their round are opting for SAFE notes.

[2] ACA Data Insights, 22 July 2021.

[3] 2019 HALO report

[4] To get a clear picture of round-level returns, they linked back the ultimate playout from a company to the actual round where capital was invested. For example, if invested in a convertible note round that later converted into equity as part of a subsequent fundraising, and then paid a return over two separate milestone escrow payments, they needed to determine what portion of each escrow payment came from shares converted in from the note into equity in order to determine that note’s ultimate return.

SAFEs – not so safe

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Had a call from an investor friend whose angel group (not in the USA) were looking at a deal where the company had presented them with a SAFE agreement that they wished to form the legal basis if the transaction. This on the basis, according to the company, that “Its the way they do things in the USA, so it must be the right way”.

The SAFE (Structured Agreement for Future Equity) was invested by Y Combinator in 2013. They are intended to be short, simple (and therefore cheap – no legal advice needed), documents that outline investors’ right to purchase equity in a start-up at some time in the futures when the company does a prised round of funding. So like a Convertible Note – but with fewer terms and, as a result, fewer investor protections than found in a Note:

  • SAFEs have no maturity date. Without a maturity date, there is no mechanism to require the start-up to repay the investor or to force the founders to convert the investors’ money to equity.
  • SAFEs don’t have a right to dividends – so in the (unlikely event) the company becomes cash generative before a conversion – SAFE holders don’t have a right to any of that cash.
  • SAFE holder receives neither debt nor equity. So legally have no protection offered by the fiduciary duty of the management to act in the interests of shareholders, nor by the legally enforceable debt terms.
  • A SAFE has no interest rate. Therefore, when the SAFE converts, the investor does not get the additional shares that come from accrued interest under a Note.

All these things make a SAFE a much less attractive structure than a Note for an investor –  and from my perspective a Note is not that good for investor (or founders) to start with:

In a 2017 survey of Angel Capital Association Members[1]:

  • 82% prefer to do priced rounds for their initial investments BUT
  • 78% had done at least one convertible note in the last 18 months.

It seems that US investors don’t want to use them, but feel they have no alternative if they want to get into the ‘good deals’. (as if any of us actually know what the ‘good deals are going to be – what they mean is ‘hyped’ deals – also associated with being overvalued deals). So glad I primarily invest in the UK, where they are, thanks to the angel tax regulations, simply unknown.

Why to the Investors not like Notes? (just a few here to set the tone)

  • The biggest problem with the convertible note is the pricing mechanism. The typical discounts to the next round is 20%. This is far too low to be fair to the investors unless the conversion occurs very quickly ( within say 6 months) after the angels invest. This discount really needs to be a minimum of 50% to make any sense.
  • The Note holder in practice has no negotiating power to protect their position at the next round.
  • The investor has none of the minority protections normally included in an equity deal.  No seat on the board, no real information rights, no participation rights etc.

But let’s get back to the problem of the company looking to get investment by a SAFE – and the investors wondering how to deal with that request.

Its actually quite easy –

Just say No.

The entire precept being put forward by the company is false.

SAFE’s are not actually used very much in the USA.

The Angel Capital Association, Angel Founders Report 2020, found that:

“While SAFE notes have captured the attention of many investors, especially accelerators on the West Coast of the USA, angels investing larger sums of money still prefer traditional deal structures. SAFE-driven incubator rounds are typically smaller investments, and when it comes to increased amounts, angels value investor protections, stronger governance and more balanced deals provided by prised equity”

So what are the typical structures used in practice by USA angels?:

  • Preferred Shares (prised round –        52%
  • Convertible Debt (Notes) –                 37%
  • Common Shares –                               4%
  • Other –                                                 4%
  • SAFE and similar –                           3%

This is consistent with the finding of the 2019 Angel Resource Institute 2019 HALO Annual Report on Angel Investments.

“While we continue to see the use of SAFE notes they are a minor percentage of all Seed transactions at 4.7%”.

Where SAFEs are used, the primary reason does not seem to be anything to do with investment anyway, but rather regulations relating to US grant funding:

“We did find SAFEs were most frequently used inMid-Atlantic Region at 12%. The Mid-Atlantic use of SAFEs may be heavily influenced by US Federal DOE, NSF, NIH, and other grant money which does not permit debt as a liability while grant funds are in use, hence early stage companies who do not wish to price their round are opting for SAFE notes.

California was #2 in SAFE usage at 10%, influenced by California incubators and possibly by science companies vying for Federal grant funds”.

The SAFE investment agreement – not a good basis for an investment, and not actually used very much.


[1] https://www.forbes.com/sites/mariannehudson/2015/08/12/convertible-notes-the-debate-continues/?sh=6c614ac87fc0