I’ve heard many individuals — starting from traders to attorneys to funding portals — make the declare that “SAFEs are not secure for traders.” Many of those critics will let you know that SAFEs (Easy Agreements for Future Fairness) must be prevented as they could by no means convert to shares. Whereas there’s a seed of fact to this conversion concern, we’ll present at the moment that this shouldn’t be a significant driver of your startup portfolio returns.
I make investments very often in SAFEs myself. In truth, SAFEs are my most distinguished safety kind in my portfolio of 200+ startup investments; my KingsCrowd portfolio analytics at the moment state that I’ve greater than 50% of my 172 Reg CF investments in SAFEs (a complete of 90, and most of my Reg D investments are additionally by way of SAFEs). Thus, I personally imagine that SAFEs is usually a completely truthful monetary safety when used appropriately.
As with many contentious subjects lately, the precise fact about SAFEs is far more nuanced and can’t be boiled right down to a dogmatic assertion corresponding to all SAFEs are unhealthy.
On this article, we’ll discover the professionals and cons of investing by way of a SAFE vs. fairness, why we imagine that traders could harm their potential returns in the event that they keep away from SAFEs, and the way sensible crowdfunding traders ought to have a look at SAFEs when investing in startups.
For a short historical past of SAFEs, fundamental deal phrases, conversion examples, and variations between conventional Y-Combinator SAFEs and crowdfunding SAFEs, try our article on crowdfunding SAFEs vs. conventional SAFEs.
Execs and Cons of Investing Through a SAFE
The professionals and cons of a SAFE first is determined by your perspective. For instance, SAFEs are sometimes thought of very founder-friendly, which is way of the rationale why they had been created by Y-Combinator within the first place. Some great benefits of a SAFE for founders and entrepreneurs are mentioned right here.
From an investor’s perspective, among the professionals of investing by way of a SAFE are:
- Simplicity and ease of execution – this may fluctuate relying on the SAFE, however sometimes you received’t have any difficult deal phrases or provisions that you just would possibly see with fairness, particularly most popular inventory, corresponding to liquidation preferences, ratchet provisions, and so forth. This implies funding rounds are simpler to execute and might be sooner to shut.
- Present founders with extra flexibility – for smaller, earlier funding rounds, taking over extreme debt can result in money circulation points for startups that haven’t but made it to product market match or discovered profitability. So how is that this a professional for traders? As a result of SAFEs don’t have an rate of interest or maturity date like debt or convertible notes, they supply extra flexibility and runway for the founders to seek out that early product market match with out incurring the prices and time of doing a proper priced spherical.
- Liquidation waterfall precedence – in lots of (however not all) situations, SAFEs are handled on par with most popular inventory within the occasion of a liquidation. Which means that SAFE holders could also be paid out previous to Frequent Inventory holders, however nonetheless junior to collectors and debt-holders.
- Doubtlessly much less dilution – I haven’t heard this mentioned anyplace else earlier than, however I’ve seen first-hand how a few of my crowdfunding SAFEs that select not to transform on the very subsequent funding spherical can lead to me holding extra fairness ultimately when it does convert. That is an possibility with some SAFEs (corresponding to Republic), the place the founders can select whether or not or to not convert SAFEs below sure circumstances. By deferring SAFE conversion to a later funding spherical, that signifies that SAFE holders received’t be diluted by any subsequent funding rounds till it does convert to fairness.
Whereas among the above advantages could also be engaging to traders, it is usually vital to contemplate the potential cons of investing by way of a SAFE as a substitute of inventory:
- You received’t obtain any dividends – this shouldn’t be a significant consideration for many startup traders, particularly since most startups are higher off reinvesting capital quite than paying out dividends. Nevertheless, SAFE holders received’t be eligible if there are any dividend distributions.
- Potential lack of QSBS tax benefits – investing in startups can provide some large tax saving alternatives for traders below IRC Part 1202 (beneficial properties), 1245 (losses), and 1044 (rollovers). One purpose {that a} SAFE is inferior to fairness on this case is as a result of one of many stipulations to make the most of these tax financial savings is that the startup funding should be in precise fairness possession. Since a SAFE is an settlement for future fairness, many tax attorneys imagine that the 5-year certified small enterprise inventory (QSBS) clock doesn’t begin till a SAFE is transformed to fairness. Nevertheless, that is one other space of rivalry, as the newest Y-Combinator post-money SAFE particularly has a clause that states it’s to be handled as fairness for the needs of Part 1202. This isn’t tax recommendation – all the time seek the advice of your skilled tax advisor.
- Lack of voting energy – solely fairness holders (Frequent and Most well-liked) could have voting rights. SAFE holders don’t include these voting rights. Nevertheless, that is much less of a con in fairness crowdfunding offers, since smaller crowdfunding traders received’t usually get voting shares anyway, even when it was supplied by way of fairness.
- Doubtlessly much less liquid – whereas startup investments are inherently illiquid, typically SAFE conversion paperwork can unrestrict your shares below Rule 144 (in case your SAFE is taken into account a restricted safety – which can or could not apply to fairness crowdfunding). That being stated, there aren’t many choices to promote startup securities by way of secondary markets at the moment anyway, so this shouldn’t be a significant consideration for startup traders who’re investing for the long-run.
Word that “lack of conversion to fairness” didn’t even make my listing of cons. In truth, it seems on the listing of professionals, since a deferred conversion to fairness can finally result in much less dilution in some conditions.
However What if my SAFE By no means Converts to Fairness?
As a result of a SAFE lacks a tough maturity date at which a convertible notice would sometimes convert to fairness, many traders robotically soar to the conclusion that “SAFEs run the danger of by no means changing”.
Sure – that’s true.
However for the standard SAFE (reminder: all the time learn your particular deal phrases!), your investments that by no means convert will find yourself being your failures and zombies, which might have returned lower than 1X your invested capital anyway. In the meantime, your SAFEs that do convert (because of a significant fundraising spherical, acquisition, or IPO) will likely be your winners.
So how are these outcomes considerably totally different than in the event you held inventory in these failures and successes as a substitute of a SAFE? The reply: they’re not considerably totally different outcomes. That’s how SAFEs had been designed to behave.
Firms that fail will see their inventory values go to near-zero (or be locked up indefinitely with no exit plan) – which finally is an analogous final result to a SAFE that doesn’t convert. You may write off the funding as a loss (albeit with probably fewer tax benefits than in the event you held fairness in a qualifying small enterprise below Part 1244).
What if the corporate is acquired or bought earlier than your SAFE converts? Most SAFEs will nonetheless be handled as non-participating most popular inventory, so that you’re coated there, too.
All this being stated, there are very uncommon examples of SAFEs and Convertible Notes that high-profile traders held which by no means transformed, so it’s doable. See the TopTal instance right here, the place traders corresponding to Andreessen Horowitz and others weren’t transformed once they arguably ought to have been.
So the danger isn’t non-zero.
However in my private opinion, traders put their portfolios at larger danger of subpar portfolio returns by avoiding SAFEs as a result of they are going to probably miss out on a number of offers that present large returns (see under dialogue about errors of omission).
If SAFEs are trusted by among the high angel traders, VC corporations, and accelerators, then it’s secure (no pun meant) to say that among the greatest startups on the planet will select to make use of them. And I don’t wish to miss out on these alternatives.
The largest takeaway for traders is that this: all SAFEs are NOT created equal. All the time learn particular deal phrases for any deal – whether or not that deal is SAFE or Frequent/Most well-liked Inventory – because the satan is all the time within the particulars of the deal phrases.
Some instance deal phrases to be careful for in any safety are repurchase rights or redemptive clauses. Whereas some earlier SAFEs had been infamous for these investor-unfriendly deal phrases, I’ve additionally seen repurchase rights on Frequent Inventory. That’s why it’s essential to all the time learn the high-quality print.
Why Avoiding SAFEs Can Damage Your Funding Returns
First, a fast statistic: in 2022 on-line startup investing (Reg CF and Reg A+), 414 out of 1308 fairness offers had been SAFEs, which means that SAFEs accounted for 32% of on-line startup investing deal circulation (and 37% of complete capital raised in 2022 was accomplished by way of SAFEs).
In case you’ve been following startup investing and have learn all of the angel investing and VC books on the market, you perceive that it’s practically not possible to find out which startups will succeed and which is able to fail within the early phases (and arguably within the development and late phases as effectively). Thus, it’s affordable to imagine that not less than a number of of the long run 100X+ startup returns seemingly reside inside that 31% of startup deal circulation supplied by way of SAFEs.
Due to this fact, it’s additionally affordable to conclude that in the event you merely keep away from all funding alternatives which are SAFEs, you might be seemingly submitting your self to omission bias (aka errors by omission). Omission bias is the place we have a tendency to guage dangerous actions (e.g. dropping 100%) as being worse than dangerous inactions (e.g. lacking out on 1000% beneficial properties).
Within the context of startup investing, this implies you’ll probably miss out on among the most profitable startup investing returns. As we’ve got mentioned, energy regulation returns are the first driver of startup investing portfolios. So what if the Uber, Fb, or Airbnb of tomorrow occurred to be a kind of SAFE choices?
Consider it this manner: what’s worse in your portfolio – dropping 100% on a number of full failures, or lacking out on a single 100-1,000x acquire that you just didn’t put money into (trace: it’s the latter, which greater than makes up for all of your failures). For instance, try this evaluation we did a number of years in the past on Wefunder’s Reg D offers and see how the returns differ on the time in the event you had missed out on Zenefits.
It’s Peter Theil’s well-known quote in motion:
The largest secret in enterprise capital is that one of the best funding in a profitable fund equals or outperforms all the remainder of the fund mixed. – Peter Thiel
SAFEs are Not the Difficulty – Unhealthy Deal Phrases are the Difficulty
SAFEs are a software for elevating capital. As with all software, there’s a proper and a unsuitable method to make use of this monetary safety.
SAFEs additionally are available in many alternative flavors. So it’s unfair to difficulty a blanket assertion corresponding to “all SAFEs are unhealthy for traders”.
I’ve seen “unsafe” phrases for traders — corresponding to repurchase rights (coated in additional element within the video right here) — in different supposedly “secure” securities, corresponding to Frequent Inventory and Convertible Notes.
Thus, merely recommending that traders keep away from SAFEs to keep away from unhealthy deal phrases can lead those self same traders to a false sense of safety. SAFEs usually are not the actual downside. Unhealthy deal phrases are the issue.
SAFEs are Used Business-Large by Prime Buyers and Platforms
It’s no coincidence that two of the highest three funding portals, Wefunder and Republic, each strongly encourage their issuers to make use of SAFEs. Or that essentially the most well-known accelerator on the planet (and the inventor of the SAFE), Y-Combinator, makes use of SAFEs. Or that AngelList syndicates, Jason Calacanis’ syndicate, and numerous different angel traders use SAFEs.
In case you have a look at among the most profitable Wefunder Reg D corporations from 2013-2016, 4 of the highest 5 had been on SAFEs, and a couple of of these had been even on uncapped SAFEs; so traders who prevented that might have missed out on 4 corporations that every one generated 12X-34X beneficial properties and would make a distinction in a startup portfolio.
As with something in startup investing, I have a look at SAFE investments as one other type of diversification. In the long run, it’s as much as every investor’s particular person danger tolerance, funding targets, and the particular deal phrases as as to whether or not investing in a SAFE would possibly make sense.
Further Sources
FINRA has a web page devoted to SAFEs right here.
