From the VC’s corner (15): Convertible and SAFE notes are here to stay, but be aware

Although I’ve done a few convertible and SAFE notes, I’m not a supporter of such (early stage) financing instruments. Neither I believe they serve in the best interest of the founders, nor I am opposing should them be the single option the founders have. They defer the discussion about valuation until a later date; generate dilution, somehow the discussion on the ownership stakes is postponed, and if you do notes on top of notes, the founders might even be in the position of not knowing exactly how much of the startup they own right at the time of pricing the next round and offering a certain percentage of ownership to the new investor(s) — the more notes the more problems in the future.

Imagine where the discussion goes when the seed funds and founders miscalculate the amount needed till the next liquidity event, and then they allow, even lead such dilutive rounds of notes, all at various caps or no caps, and when the Series A firms come to the table and things get tough at pricing the round, all discover they own less than they had thought.

Fred Wilson’s suggestions, in such a case, for the entire angel/seed sector (founders, angels, seed investors and lawyers), which you can read here, resume to: do priced equity rounds instead of notes, as the cost of doing a simple seed equity deal is low, and it takes a few days only (with a professional seed investor); the first convertible or SAFE note should have a cap on the total amount of notes that can be issued (like $1m or $2m); don’t do multiple rounds of notes with multiple caps; make sure you have a pro-forma cap table at the closing of each note that shows how much each party would own if the note converted immediately at different prices.

If you’re doing really great, like growing significantly and rapidly, and with a reasonable (read low) burn rate, the VCs might come in front of the company’s place with their limos “begging” the founders to take the checks; but the round also comes with stress, anxiety and verbiage, especially if you’ve done notes. When all’s great, they’ll do whatever it takes to close. However, if you’re doing like most of the people, hanging on in the market, and you’re desperate and thinking in the middle of the night at the employees you have to feed, talent you risk losing, and money you owe, taking notes to run the show is your best choice. Then, do it, man, when you’re hungry you have to survive. One comment though: make sure you give same/similar note terms to different investors in the same round, and don’t raise from people who are going to hassle you and kill your strategy and ideas in the board. Later, if and when things take off, you’ll find a way with those dilutions. The safe entrepreneurship does not exist, and a lot of great companies would not exist today without convertibles and SAFEs.

As a seed investor in this part of the world, notes are acceptable though (with all my reserves)… if not awesome, as some would say; they can be converted into debt when the company becomes a zombie and provide a way out for the stuck investors, and they get paid before equity (if you don’t convert.)

The founders should take time to read through and understand the conversion terms under various scenarios, and be aware that the terms and valuations of subsequent investors will have a major impact regardless of the notes’ terms and options pool.

YC did the SAFE public, an open-source structure you can use at your own leisure. As Amos Ben-Meir states, in a post to Fred’s article on the “Unsafe Notes”, “the new YC SAFE released in October 2018, called the ‘Post Money SAFE’, takes some further steps…”; using the post money SAFE and reading the associated ‘user-guide’ “should give founders and angels a much better idea of what they are getting in terms of future ownership.”

No matter what, a priced round inherently dilutes pat investors, and the layers of previous CNs or SAFEs that convert will further dilute them.

You’ll find here a quick tool executed by Michael Mullany (thank you, Michael) which helps the founders see what their ownership is under combinations of note caps, discounts and priced round valuations (might not be thoroughly checked yet, but at least you’ll get a flavor of how dilution works.) The notes in this tool are modeled as “new style” post-money YC SAFE notes, where the SAFE Post Money is the pre-money for the first priced round.

My today’s preferred: Buttsss — A great collection of round and b(ea)uttiful butt GIFs you can use on your pitch deck, corporate presentations, marketing campaigns, school assignments or motivational speeches…

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Ciprian Ghetau

Repeat entrepreneur, tech investor, Founder & MP @ BSC, formerly M&A Head @ CP (now Oaklins), Co-Founder & COO @ ATLNG, alum @FreemanSchool and @FulbrightPrgrm.