Experienced early-stage investors are familiar with convertible note investments, which have evolved slightly but have been around in largely the same form for more than two decades. Convertible note investments start as short-term debt with interest and a specified maturity date. These notes are typically convertible into equity at a discount to a future investment round (“a qualified financing”) where a valuation for the company is established. Convertible note formats can be a good choice when there is not enough data to establish a formal valuation for a company (e.g., a pending milestone such as a regulatory approval) or for needed bridge funding to have time to raise the next priced equity round.
A newer form of agreement, first developed by the accelerator Y Combinator in 2013, is called SAFE (Simple Agreement for Future Equity). Like convertible notes, SAFE agreements convert to equity upon qualified financing. However, unlike convertible notes, SAFE investments have no interest rates or maturity dates.
SAFE investments have been touted to have the following advantages:
- Simplicity – SAFE agreements are typically short and have fewer terms to negotiate between the parties.
- Reduced legal cost – In addition to potential reduced legal cost from having a simpler initial agreement, there are potentially lower future legal costs than convertible notes because there is no maturity date. That is because convertible notes may need to be extended or otherwise revised upon reaching the maturity date if the conversion milestone has not been reached.
- Flexibility – Having no maturity date gives the early-stage company freedom to establish timelines and strategies without the constraint of having a loan come due at a specific date.
SAFE are company friendly and offer some advantages for young companies raising capital. However, for investors in early-stage companies, the benefits for the company are primarily disadvantages for the investor. Convertible notes are better for investors than SAFE in most cases. The flexibility, touted by some as an advantage of SAFE, is realistically only an advantage to the company; it is a disadvantage to the investors. For example, let’s say that a convertible note is placed with investors and has a one-year maturity date, an 8% interest on the principal amount, and a 20% conversion discount to a future investment round expected to be closed within one year. If the company does not reach the investment milestone, then the note may be extended and otherwise adjusted with agreement by the investors. However, at a minimum, the interest rate will continue to apply and offer some compensation to the investors for the time value of their money. There is no such adjustment or compensation to investors for the company not meeting expected milestones for a SAFE agreement.
There is no requirement in a SAFE agreement that the debt is ever converted to equity. If the company somehow manages to achieve positive cash flow without needing the qualified financing, then the company is under no legal obligation to ever convert the SAFE. Of course, if there is no qualified financing in most cases, that means that the given company is struggling and investor’s money is at risk. However, the investors have less voice in how to overcome the struggles. They cannot declare a default and use that as leverage to force steps to protect their interests.
There are also tax considerations that are potentially disadvantageous with SAFE, including the potential inability to write off a complete loss. Even the touted cost advantage of SAFE is not, in most cases, a meaningful consideration. While SAFE agreements are simple, they are less familiar to many investors and convertible notes themselves need not be complicated while still offering better protection to investors. For most investors, convertible notes are more familiar. There are templates readily available to reduce legal costs. They will typically create fewer concerns and fewer questions from the target investors. Capturing the investment is the most critical consideration for the company, even if it means they have to put forward a plan that fulfills a qualified financing within a specified period.
In summary, although SAFE agreements have gained popularity over the years, early-stage investors should be cautious about them. Indeed, VIC Tech and our affiliated VIC Investor Network will simply not consider investment via a SAFE. We do not believe they offer sufficient protection to the interests of our investors. For additional thoughts on investor protections for early-stage investors see Protecting Early Investors in Capital-Intensive Life Science Companies.