Issue 21.4, Auckland, 3 May 2021 

SAFE notes or Simple Agreement for Future Equity have quickly become the instrument of choice for early stage funding since this was first made popular by Y Combinator in 2013.

On a practical level, SAFEs address a familiar problem with trying to value an early stage company which typically has little to no comparative industry data to evaluate. Consequently, most valuations for early stage companies are arbitrary at best and outright fantasy at worst.

The SAFE note completely avoids the question of valuation and moves straight towards the valuation cap. The logic being, rather than debate an arbitrary valuation for an early stage company, the parties just agree on a valuation cap at some point in the future when the company is seemingly more established where such valuation matrices become more realistic.

Unlike a convertible note which is in effect debt until it is converted, the SAFE has no bearing on the company’s balance sheet and as such doesn’t encumber its assets for future financing rounds.

Problem solved, right?
Well for the company perhaps, especially if it’s a well written SAFE. For the investor however there are a number of vulnerabilities.

The first of which is a rather optimistic underlying assumption that the company will be successful enough to get to the point where it will have a qualifying financing round.

This assumption does not take into account that most early stage companies fail outright within three years and many more just end up being zombies, never quite able to achieve the next qualifying finance round. This almost always results in disheartened entrepreneurs which in turn causes distraction and a long drawn out death of the company.

Of course a small number of these companies do indeed succeed in their qualifying round and an even smaller number actually succeed to give early investors an exponential return.

Risk for the Investor
The problem with this assumption is that the investor bears all the risk during the most vulnerable stage of the company while receiving little if any return that takes into account their time value of money (TVM) and by extension their opportunity cost of funds.

Furthermore, the investor is in legal limbo receiving neither the entitlements of a shareholder, nor benefiting from the obligations of a debt holder. The company is not obliged to provide any updates or have any imperative or incentive to fulfill their end of the obligation after the investment has already been made.

The only argument that can be made to the investors is that if they didn’t think the company was going to succeed to begin with, they should not have made the investment.

The Bottom Line
All in all, this is a rather one sided arrangement where the main reason an investor would invest under a SAFE is due to some misguided fear of missing out (FOMO).

This logic, in our view, holds the same rationale that one can only win the lottery if one buys a lottery ticket. Going on that same principle, the opportunity must be so great that the risks are worth taking (and you’re good with buying a very expensive lottery ticket!).

This is a rather hard argument to make for a company that is so early in its development stage that we are unable to resolve an objective valuation.

A Case for the Convertible Note
Fortunately we do not have to look far for a more equitable way to address the investor-investee relationship. Prior to 2013, the traditional convertible note in general, and the mandatory convertible note specifically, was the second most common investment option next to straight equity.

A well drafted convertible note agreement can provide the company much needed funds while protecting investor interest.

Our Approach to Drafting a Convertible Note Agreement
Firstly, we rarely do mandatory convertible notes for the first investment. If we do them at all, it would typically be after the terms of the first note were met and thus concluded without incident.

This is so we do not overly extend ourselves into an investee company which may be problematic or otherwise not have a positive experience.  A mandatory convertible note as a first investment may force us to stay in a bad relationship which benefits neither the investor nor the entrepreneur.

We are however more open to this in follow-on financing rounds as increasing our stake may increase our strategic influence in the company, extending on what has already proven to be a good relationship.

While the relationship with the entrepreneur may evolve over time, we are now more committed to the company and are in a position to take corrective action if needed.

Secondly, our note always accrues interest to take into account both the TVM and opportunity cost of capital for investors. This also provides an incentive to the investee company to meet their milestone targets to trigger conversions.

Criticism of this provision is that it makes the entrepreneurs’ interest less aligned with the investors. While a valid point, it only becomes valid if milestones are not being achieved. The momentum created is meant to mitigate against the effects of distraction and coasting with a ‘business as usual’ attitude that lacks urgency.

The Win-Win
Ultimately, both the investor and the company win with a motivated management team.

Finally, we structure notes to only convert upon management achieving the key milestones they have set out in their projections to us. This prevents overly optimistic forecasts designed to purely misrepresent an investment to investors.

Understanding that the marketplace can be unpredictable, barring a Black Swan event, companies should be able to achieve objectives within a reasonable band of their contracted milestones.

There are always provisions that our note may not convert at all. While not ideal, this is not the worst outcome for investors as by remaining debt holders, they rank ahead of even preferential stockholders which puts them in a much stronger position to restructure the business if needed or if worse comes to worst, be in the top tier of a liquidation preference.

The convertible note should provide an incentive to the management while at the same hold them to account for the representations they make during the initial investment pitch process. After all, an investor needs to have a more than reasonable expectation that the juice is worth the squeeze.

The Obris Approach to Structuring Deals
This food for thought offers insight on one key aspect our our deal making, one that puts the investor first and holds the company in which we invest accountable. This consistently serves as a win-win for our members who invest.

Marvin on behalf of the Obris Team
Marvin Yee is a partner at Obris Crown Private and Managing Partner at Crown Financial Services.