Deal Terms

SAFEs – not so safe


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.