There was an article in Techcrunch yesterday on SAFE notes and how they were surprising entrepreneurs. The headline is a bit of clickbait. I read the article and then emailed it to some attorneys in Chicago that really understand venture. Their responses were pretty uniform.
Here is the premise of the article. SAFE’s are unsafe for entrepreneurs because of the dilution hit they take in succeeding rounds of financing. Presumably, this also includes early investors. Here is a quote I lifted from the article.
We have observed the following in our own recent direct experience investing in SAFE and convertible notes: that many founders have a tendency to associate the valuation cap on a note with the future floor for an equity round; that they further assume that any note discount implies the minimum premium for the next equity round; and that many founders don’t do the basic dilution math associated with what happens to their personal ownership stakes when these notes actually convert into equity.
To be clear, this can happen with convertible debt notes too.
I mean let’s be honest. When an entrepreneur wants to do a convertible debt note or a SAFE with an $8M cap, they are really saying that’s what they think the company is worth $8M but they are willing to give up a 20% discount (plus interest in the case of the note) to get money in the door.
Why aren’t we all just doing a priced equity round and start the conversation at $6M to $6.5M pre-money? Or, if that’s going to be the post, start the conversation lower at $4M to $5M.
Priced equity rounds are better for entrepreneurs and investors because everyone knows exactly where they stand on the cap table.
A company like eShares, who we use at WLV, can calculate it all and keep track for you but the math can get messy. Invariably, the note is extended, the SAFE is extended and more squishy equity is raised in the hope that finally there will be enough traction to raise a Series A at a valuation higher than the cap on the instrument.
When entrepreneurs don’t have enough equity in the deal, venture capitalists don’t want to invest. That’s but one reason capricious early round investors that go for 50% of the equity at a cheap price are bad for everyone. It’s why entrepreneurs should stay away from brokers who take equity and cash out of a deal for fundraising services. Bloodsuckers ruin ecosystems and companies.
Mike Moyer wrote a great book about divvying up equity called Slicing Pie. Brad Feld and his partner Jason Mendelson wrote a book every entrepreneur should have called Venture Deals. They explain the puzzle that the cap table can be.
The responses I got from Chicago attorneys that have been around the block several times on venture were interesting. They know their stuff backward and forward and are some I recommend often to entrepreneurs. They highlight why these instruments are popular. Maybe WLV should host an event just on legal docs and cap table management.
First, it’s hard to know how to value a company at a Friends and Family round. Using a debt instrument or SAFE might be a good idea, as long as it preserves equity for the founders. Setting a high cap is insurance. At the same time, the entrepreneur and early investors shouldn’t anchor on that cap as a true valuation. But, doing that goes against behavioral psychological principles.
If you do that, you might want to put up a sign in your workspace that says your company isn’t worth what everyone says it is on paper…..yet.
Second, these sorts of instruments are great for inside rounds when a company is between financings and needs a little cash to get them to the next round. Figure on 120 days out. That’s not 12 months of runway. It’s 3 months of negotiating (breathing) room to give an entrepreneur some leverage going into the next round.
It’s worth noting that most startups are not rocket ships until later rounds of financing. They stumble and bumble along searching for their booster rocket. Headline financing is just part of the game, it’s not the true value of the company. You only know that on exit.
I would urge all entrepreneurs to have the tough discussion on a valuation at seed stage. Yes, it’s more expensive. Yes, it’s sometimes a really hard discussion. At the end of the day though it’s better for the company.
At the end of the day, I think the fact that we see so many debt instruments boils down to greed. Founders are skeptical and don’t feel good when their company doesn’t get a high valuation. Early investors want big jumps in valuation. Some early investors try to take too much equity early in the process and don’t look out for the long haul of building a company. Greed kills. Pigs get slaughtered.
For goodness sakes find an attorney that knows what they are doing. You might pay a bit more for a good one but it will pay in spades with the guidance you get. Most Seed and Series A term sheets are pretty boilerplate and the documents don’t cost a fortune to do. You are paying for their expertise so things don’t get screwed up today or in the future.
As a founder, you need to speak for your company and the future of your company. Your ego takes a backseat.