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Episode Date: December 03, 2020
https://youtu.be/_3n5PReB0is
Top Insights
- Convertible notes are safer for investors.
- SAFEs are more founder-friendly.
- There are safes, convertible notes, and priced rounds.
- Convertible Notes: These were created as a faster, cheaper alternative to doing an equity round. The expectation is that notes are going to convert into preferred stock in the next round, rather than be pre-paid. Nobody wants to get their money back, they want to convert it into shares in the future. While outstanding, it is a debt instrument, so it doesn't show up on the cap table. It is a liability on your balance sheet.
- SAFE: A simple agreement for future equity. Created by Y-Combinator. They came up with it as an alternative to the convertible note. The idea is that you download the form, fill in the blanks and you're good to go. There's not a lot of negotiation. There's no "your form my form" or lawyers getting involved. You get the money into the company cheap and fast. That's the idea behind it.
- A SAFE is not debt. It's not equity. It's something quasi in the middle. It's a contract where the company is promising and agreeing that they will issue the investor some sort of equity in the future, in connection with the next round.
- Both SAFEs and convertible notes have conversion terms. You can have discounts and valuation caps in both. An automatic conversion feature triggers both.
- A SAFE is not a debt instrument, so there is no interest rate. It does not have a maturity date, so there's no forcing function for the mixed financing to have to happen in a certain period of time.
- A SAFE is set up to convert into a shadow series of preferred stock. This means that when your new investor comes in and buys series A preferred stock, and the SAFE converts in that same round, the SAFE is going to convert into what's called a series A-1 preferred stock. It's going to be exactly the same as the series A, except for the economics. The economics are tied to the conversion price, as opposed to the new money price.
- In convertible notes, although you can structure them to convert into shadow series, more often they actually convert into the actual series that the new money is purchasing. That means they get a step up in liquidation preference. If they converted at .80/share and the new money is being put in at $1/share, the conversion calculations are based on .80/share, but their liquidation preference is based on $1/share. Which is good for the investor.
- The typical interest rate on convertible notes is 6-8%.
- SAFE structure favors the founder. The investor gets no additional value for being early, and since there is no maturity date, there is no guarantee the money converts to equity. There is no recourse for the investors who give money through a SAFE contract. Also, a SAFE states that in a dissolution you have to treat it as debt, but everywhere else it states that it is not a debt instrument.
Y-Combinator created SAFEs to neutralize investors. They wanted to take power away from investors and put power into the hands of founders. It was created with good intentions to protect founders. - Jason