THE RISE OF THE SAFES

Increasing Popularity of Future Equity Agreements

WRITTEN BY:

Trent Read, Partner at EP

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MARKETS WILL BE MARKETS, AND WHEN A MARKET IS HOT THERE WILL ALWAYS BE COMPETITION TO GET INTO THAT MARKET.

DURING THE DOT-COM RUN  it became much more streamlined to go public.  DURING THE REAL ESTATE BOOM  of the last decade we saw lenders streamlining the loan approval process in an effort to provide as many mortgages as possible.  NOW  we are seeing early stage investors hungry to deploy capital finding ways to innovate seed stage investing. On the forefront is the Silicon Valley accelerator Y Combinator. Y Combinator introduced the world to their Simple Agreement for Future Equity (“SAFE”) in late 2013, and by virtue of the founder-friendly terms, these instruments are increasingly popular with entrepreneurs.

SAFEs look and feel a bit like a convertible note and a warrant got together and had a very company-friendly baby, who is also nice to investors as long as the market remains strong. The love child might turn on investors a little, if the market takes a hit, as it doesn’t provide investors anything in the way of downside protection. The risk isn’t that much greater than that of a pure equity investor, but equity investors at least have some ownership. SAFE agreements only provide ownership to investors, if the company receiving funds eventually has some form of liquidity event.

Keep in mind, this instrument has been pioneered by Y Combinator of Airbnb and Dropbox fame. These are some of the most successful investors in the business, and they achieve downside protection in other innovative ways. They are a very exclusive accelerator with literally thousands of startups vying for admission – over 95% of which are rejected. The blessed few that are accepted then have a pretty good chance of future success. This chance is enhanced by everything that Y Combinator provides to its cohorts. The Y Combinator stamp of approval means there is a very high probability of qualifying funding rounds that would convert the “Future Equity” instruments into actual priced equity. So, the additional “risk” Y Combinator is taking on is mitigated by the rest of the machine that surrounds their investments. Even then, Y Combinator does generally take a 7% equity stake for their investment. In other words, a SAFE in their world is actually a safe bet.

Future equity agreements being offered by anyone other than Y Combinator would likely be just as founder friendly, but if not wrapped within a similar system they could be as risky of an instrument as you could imagine for investors. SAFEs are the brainchild of Carolynn Levy of Y Combinator, who has stated that the goal is for future equity agreements to become as ubiquitous as convertible notes. That may yet happen, but they are likely best deployed by investors groups that could similarly mitigate their risk as Y Combinator is able to do. They would also likely become almost non-existent in a more capital constrained, challenging start-up economy. Though future equity agreements are not exactly analogous to lax standards for underwriting IPOs or mortgages, just as those markets really tighten up when hit with a shock to the system, we’d be surprised to see much SAFE activity, if the power shifted more to investors and away from entrepreneurs.

THE STRUCTURE OF FUTURE EQUITY AGREEMENTS, BRINGING IT ALL TOGETHER

In discussing future equity agreements we have jumped right into the market dynamics with only a cursory mention of the structure. We won’t dive in too deep here explaining the structure of a SAFE as Y Combinator does a great job of explaining this on their website (https://www.ycombinator.com), but the quick summary is that the agreement is written to be as simple as possible–the investor holds a warrant-like instrument, the instrument has a valuation cap, no interest, no debt, no conversion deadline, and fewer restrictions on what qualifies as a conversion event, as compared with a convertible note.

It’s kind of like the entrepreneur is Lloyd Christmas, and he’s saying to the investor, “That’s as good as money, sir. Those are I.O.U.’s. Go ahead and add it up, every cent’s accounted for. Look, see this? That’s a car. 275 thou. Might wanna hang onto that one.

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For the sake of founders everywhere: We hope that SAFEs do increase in use and popularity.

For the sake of investors everywhere: If you’re going to use SAFEs, you’d better avoid the Lloyd Christmases of the world.

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Trent Read - PartnerAUTHORED BY TRENT READ

Trent has been a CFO of two venture/growth equity-backed companies that ranked on Inc. Magazine’s list of fastest growing companies in the country which he successfully led from their infancy to full liquidity events. He began his career as an Analyst in investment banking with Deutsche Bank. He was then a Senior Financial Analyst for a $200 million business unit of Honeywell. He then returned to investment banking as an Associate and then VP at Wachovia Securities and Sagent Advisors respectively. He worked with media, digital media, telecom, software/SaaS, and internet infrastructure companies on transactions that varied from multi-billion dollar LBOs to small growth equity capital raises. Trent is now a partner at EP and is the head of EP’s Utah valuation practice. 

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2018-11-02T20:24:46+00:00