Early-stage companies often rely on Simple Agreements for Future Equity (SAFEs) and convertible promissory notes to raise capital either prior to a company’s first priced preferred equity round, or to raise bridge capital between priced equity raises. In addition to the economic terms, investors considering participation in these financings should seek visibility as to the other investors in the round, and the potential misalignment of incentives among those investors.
Raising funds via SAFEs and convertible notes has a number of advantages for the issuer, not least of which is the speed with which such financings can be achieved. SAFE and convertible note financings involve significantly less documentation, legal lift, and expense than a standard preferred stock financing. Further, depending on how a SAFE or convertible note is structured, it can allow an early-stage company experiencing rapid growth (and, accordingly, valuation) to raise capital without selling equity at a valuation materially lower than the valuation it can justify in the next 12-24 months.
Similarly, SAFEs and convertible note rounds can appeal to early-stage investors. Again, the documentation is relatively straightforward and, to a large extent, consistent from transaction to transaction. Further, more recent iterations of Y-Combinator’s form SAFE include investor-favorite provisions that protect investors from dilution associated with the issuance of other convertible instruments.
That said, most SAFEs and convertible promissory notes include amendment provisions providing that their terms can be amended or waived with the approval of holders representing a majority of the total invested amount. Such amendments can fundamentally change the terms on which investors originally based their decision to participate in the SAFE or note round. For example, common amendments include reductions in the conversion discount, valuation cap, and/or required equity financing threshold at which the SAFE or note is required to convert. Perhaps more drastic, we increasingly see companies raising significant funds in multiple SAFE or note rounds without ever needing to do an equity financing prior to a liquidity event. In those instances, it is not uncommon for the company to get a majority-in-interest of the SAFE or noteholders to convert into equity on terms that bear little or no relation to what was contemplated in the original investment instrument.
Of course, you may ask, why would a majority-in-interest of the SAFE or noteholders agree to an amendment or adjustment that is not in their best interests? The answer is that savvy founders will often ensure that a majority-in-interest of the investors are “company-friendly,” with incentives that may be very different than those of a passive investor. For example, founders and their friends and family may control a majority of the round. Similarly, SAFE and noteholders may already have equity interests in the company, such that they see a net benefit to agreeing to changes in their note or SAFE terms that, viewed in isolation, are subpar.
Accordingly, before making a material investment in a SAFE or convertible note financing, investors should have a clear understanding of the maximum amount that can be raised, and the likelihood that a significant number of those investors may sign off on amendments that undermine the original deal terms.
