There are two problems with early stage investing: how much is a company worth when truthfully, it is still worthless; and how can early stage companies protect themselves from over dilution when they are, effectively, worthless. Two sides of the same intractable coin.
To solve this, VCs and entrepreneurs need a quick and easy way to provide seed funding, without a long, drawn out negotiation, onerous debt covenants, or a crazy valuation that could hurt the investor and/or the entrepreneur. YC came up with a novel way to do this in 2013 called the SAFE note.
When Sputnik ATX funds a company in our program, we give them $100,000 through a SAFE note. This begs the questions, what is a SAFE note, and why use it?
This article answers these two main questions, and summarizes a few of the terms of the Sputnik ATX SAFE note.
First, what is a SAFE Note?
A SAFE note is a Simple Agreement for Future Equity. This note provides that should we give you funding in the accelerator program, you agree to provide us equity in the future at terms outlined in the note. Think of it this way: Billy sees his friend Mitch enjoying a Popsicle by the ice cream truck but has no money. Mitch offers to give him the money for his ice cream today if he’ll pay him back tomorrow with ice cream of slightly greater value, hopefully Amy’s Ice Cream because that is just the kind of cool person you are.
That is how the SAFE note works, we give you money today, and you give us shares in your company tomorrow, preferably a good deal for both of us because you’re growing fast.
The SAFE notes gives us the right to trade the note for equity (shares in your company) when you raise additional funds in the future in a qualified round of funding that is priced by the future investor.
SAFE notes have some preferred qualities to convertible debt notes. Unlike debt, the SAFE note does not come with onerous restrictions and covenants that risk insolvency, induce regulations, force interest payments, complicate subordination agreements, etc. It sits on your balance sheet as a form of equity. Think of it as happy equity as opposed to angry debt. Ben and Jerry’s, not frozen ice milk in one gallon plastic tubs.
The SAFE note allows Sputnik ATX to invest in your company today, at a price that will be determined in the future, that you can influence in your favor by channeling your inner worker bee and making honey. No need to haggle over valuation with us now, just get funded and get to work. The note will convert in the future when you raise more serious funding and the value of your company is better understood and defined by you and your future investor.
Why use a SAFE note?
SAFE notes have great economic value to both investors and start-ups. For investors, SAFE notes mean that we don’t have to negotiate valuation with all the companies we’re looking to bring into the accelerator. That is a time killer for both the companies and investors, and the resulting valuation is never better than a poor guess regardless of effort. We punt this decision down the road and agree to just convert the note when that value is clearer, and the investment large enough to justify more precise pricing.
SAFE notes also permit companies to clean up their early-stage cap tables without fear of triggering convertible debt covenants that might prevent them from making needed changes. A cap table (for all you cool rookies out there) is a list of everyone who owns shares in your company, as well as the type of shares, value of those shares, and rights of those shareholders; along with the same information for all debts and debt holders.
We don’t like convertible debt for many reasons: it can lead to sub-optimal decisions to avoid covenant defaults, but also can skew debt ratios for some companies that would benefit from SBA loans in the future. SBA loans are a great way to access cheap funding, so forcing early stage companies to take debt seems like a bad idea for equity holders that would benefit from this.
The Sputnik ATX SAFE Note has a couple of key provisions you should understand. Note: there are more, but these are just the ones we get asked about the most.
- The note converts at a 30% discount. This means that for the $100,000 Sputnik ATX provides you, it will convert in your next round of priced funding as if I gave you $130,000. That is so that we can capture a small fraction of the value we created before your next funding round. Given the fact that most early stage companies increase value between 100% and 200% between rounds, we think this is a good deal for the entrepreneur. We’re getting you Ben and Jerry’s today, so make sure to give us some more tomorrow.
- The note converts at a maximum valuation (cap) of $4.5mm. This is to protect us from getting diluted in a scam round with your cousin Vinnie where he invests a small amount of money at some crazy high valuation, just so you can cram us down. This is, obviously, not cool. Of course, you would never do such a thing to your VCs, so I assume the cap will not bother you.
The real implications of these two provisions are that they only work if you can grow your company value faster than our discount rate (hooray for everyone) and if you’re company isn’t already worth more than $4.5mm when you start the accelerator program.
The hard truth is that many people won’t apply to the accelerator because of this second point. They think their idea is worth a whole lot more, so we don’t see them. That is awesome for us, because funding entrepreneurs who have over-inflated valuation bias leads to failed companies (losses) down the road, and we’d like to avoid that kind of investment also.
In this way, our SAFE note is poka-yoke designed to help us screen for entrepreneurs who are in the Sputnik ATX sweet spot: MVP and at least one customer. These are the makers who are ready to grow, and we are here to help make that happen.
We wouldn’t have it any other way!