How Safe Is a SAFE?
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Today, I’m going to dig into a fairly nuanced area of crowdfund Investing. If you’d like to make more Money with your money by investing directly in private companies—and who doesn’t—please invest the time to learn more about SAFEs.
What Is a SAFE?
A SAFE is a Simple Agreement for Future Equity. The idea gained traction after the prestigious Y-Combinator accelerator began using a standard form of the instrument for its early-stage Silicon Valley startups.
The Securities and Exchange Commission published this definition with an embedded caution:
A SAFE is an agreement between you, the investor, and the company in which the company generally promises to give you a future equity stake in the company if certain trigger events occur. Not all SAFEs are the same and the very important terms governing when you may get the future equity may vary across the SAFEs being offered in different Crowdfunding offerings. Despite its name, a SAFE may not be “simple” or “safe.”
Note that the emphasis is in the original document.
It is my understanding that most of the SAFEs in use are built on the Y-Combinator template, but the accelerator cautions that if you change one word, they don’t stand by the document. Most in circulation in crowdfunding circles have been tweaked.
The investors who invest in Y-Combinator startups are some of the wealthiest, most sophisticated and experienced investors in the world. Many have started and run successful tech businesses themselves. When they did, they may have raised capital using a SAFE. They understand how it works.
Why Invest in SAFEs?
There are two related and good reasons for using SAFEs. This is especially true for Y-Combinator businesses.
Templated Efficiency. When a Y-Combinator company uses the template for fundraising, the investors and entrepreneurs immediately understand the deal. There are no mysteries. Most Y-Combinator companies graduate using valuations in a narrow range, so even that fundamental aspect doesn’t vary much.
Founder Friendly. Using SAFEs from a trusted source like Y-Combinator is another way of supporting a startup at its most vulnerable moment. True startups like those going through an accelerator have no revenue and limited cash. Being forced by investors to spend money on attorneys to negotiate and document deal terms would represent a penalty.
As an impact investor, I hope you value being founder-friendly. You don’t want to penalize the entrepreneurs you ostensibly want to support. That efficiency ultimately works to the advantage of investors. The money saved goes to more productive purposes developing products and generating revenue.
Why Not Invest in SAFEs?
Fundamentally, there is one primary reason not to invest in SAFEs: the agreements work best for a specific type of company, high-potential tech companies that will soon raise millions in venture capital.
That description doesn’t necessarily mean those companies are better investments led by better or smarter people, but they are different from many of the companies offering SAFEs on regulated investment crowdfunding portals.
There are tech companies on crowdfunding portals, but most haven’t been vetted by Y-Combinator or comparable accelerators. Therefore, they may not justify a similar valuation and may not have the same prospects for raising venture capital.
That last bit—raising venture capital—is critical. If the SAFE converts to equity only upon raising millions of dollars of venture capital, getting sold or having an IPO, you may never get your money back. It is possible that the company could be successful by many measures and never complete a round of venture capital, get sold or have an IPO.
If the company’s Growth isn’t impressive enough for VCs, the business could potentially raise more modest amounts of money via crowdfunding to continue growing and building, succeeding at business and never triggering your conversion to equity.
Imagine you invest in a tech company on a crowdfunding portal at a $10 million pre-money valuation. In five years, the company is demonstrably worth $50 million but hasn’t raised a venture capital round, been sold or completed an IPO, triggering your conversion to equity. What do you own?
The answer to that question depends on the specific verbiage of the SAFE the company is using. It is conceivable that you could end up with little legal claim on any of the value you helped create.
What Is the Best Alternative to a SAFE?
That was a bit of a trick question. There is no single best alternative to a SAFE. In limited circumstances, a SAFE is best. Which investment instrument is best depends on the specifics of the deal.
Before SAFEs were used commonly for tech startups, entrepreneurs often raised capital with convertible notes. These instruments are typically structured as loans that give investors a clear claim to get their money back with interest by a deadline.
Investors bought them, understanding that a pre-revenue company that fails because it runs out of capital won’t likely be able to repay the note. Still, the note structure provided some protection in the scenario we imagined above. In that imaginary situation, the company would most likely have either redeemed your note by paying you cash or converted your note into equity—both better than SAFE limbo.
Let’s be clear, too, that templates for convertible notes are easy to find with a quick Google search. It doesn’t have to be burdensome to entrepreneurs.
For companies with immediate or short-term prospects for revenue, revenue-based financing notes can work well. Thankfully, they are becoming more popular. These structures can provide investors with better-than-stock-market returns without requiring the company to be sold or go public. In the end, the cost to the entrepreneur could be lower than with any form of equity while still providing risk-adjusted returns to investors. Win-win.
For companies that have the cash flow to issue traditional debt with payments beginning promptly, like a bank loan, can be the cheapest option for the issuer and provide appropriate returns to investors.
Common stock and preferred stock issuances make sense for slightly more mature companies that have raised enough capital over time to have hired lawyers to do a bit more work in preparation for an offering.
What Does This Mean for Crowdfund Investors?
When you are conducting your due diligence on an investment and see a SAFE offering, don’t stop. Be cautious. I encourage you to find and read the SAFE agreement. By regulation, the document should be available to you. Read it.
A SAFE is a shorter, simpler agreement than many other documents I’ve seen. You can likely read the entire document in a few minutes. Don’t be afraid to ask the issuer questions if you see anything that concerns you. If you don’t get satisfactory answers, that may be a signal to stop.
Remember, too, that an investment instrument that isn’t a SAFE isn’t always better. Don’t click the “invest now” button on an offering simply because it isn’t a SAFE. Take the time to understand the deal terms and determine if the company’s ability to create value aligns well with them.
Proceed with Caution, but Proceed!
Don’t be daunted by the need to learn more about investing. One of the great things about regulated investment crowdfunding is that you can start small.
I once found an offering (I wouldn’t have touched with a ten-foot pole) that had a minimum investment requirement of just one dollar! Climatize always offers a minimum of $5. SMBX offers a minimum of $10. There are hundreds of offerings live now with a minimum of under $151.
Every time you make an investment, you’ll learn something new. You’ll get better at it.
One great way to make investing fun and easier is to join the Impact Cherub Club. We meet monthly to review offerings and share the burden of conducting thoughtful due diligence.
Every Friday, I share my “Impact Pick of the Week” along with a thorough due diligence report. To get my weekly pick or join the Club, you’ll need to become an impact member of the SuperCrowd—that is, a paying subscriber.
Please join the movement. Together, we’re changing capitalism!
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If a location is not noted, the events below are virtual.
Impact Cherub Club Meeting hosted by The Super Crowd, Inc., a public benefit corporation, on August 20, 2024, at 1:00 PM Eastern. Each month, the Club meets to review new offerings for investment consideration and to conduct due diligence on previously screened deals. To join the Impact Cherub Club, become an Impact Member of the SuperCrowd.
SuperCrowdHour, August 21, 2024, at 1:00 PM Eastern. Each month, we host a value-laden webinar for aspiring impact investors or social entrepreneurs. At this month’s webinar, Devin Thorpe will provide a “Step-by-Step Guide to Raising Capital from the Crowd.”
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Originally Published on https://www.superpowers4good.com/
