Boston Startups Should Avoid the YC Post-Money SAFE

Y Combinator’s “Simple Agreement for Future Equity” (SAFE), in its original form, was presented by YC as an alternative to convertible notes. It was effectively a convertible note without interest or a maturity date. While very popular within Silicon Valley, it remained a minority instrument almost everywhere else, including the East Coast, because most investors (not without justification) felt it was an imbalanced agreement that gave investors too few protections.

Entrepreneurs can get into trouble when attempting to replicate Silicon Valley norms and fundraising structures in tech ecosystems where the community approaches things differently. 

Recently, Y Combinator completely re-vamped the core economics of the SAFE, having it convert on a post-money instead of pre-money basis. This totally changed how the conversion of SAFEs into shares works, and made them far riskier of an instrument for startups; particularly because the new Post-Money SAFE has a very unique anti-dilution mechanism built in that can seriously penalize founders/the common stock if the startup does more seed rounds after the initial SAFE. Using a Post-Money SAFE can, in many contexts, mean far more dilution than if you’d used other acceptable alternatives. 

While SAFEs never became the dominant seed instrument outside of Silicon Valley (including in New England), we suspect that their more aggressive economics will make them even less utilized going forward. Seed equity and simple convertible notes with reasonable maturity dates and low interest are viable, and better, alternatives. In the latter case of simple convertible notes, they can be closed just as easily as a SAFE, with similar legal cost. 

For a deeper dive on this topic, see: Why Startups Shouldn’t use YC’s Post-Money Safe.

The Value of Startup Accelerators

Background Reading:

Boston is known as an epicenter of top-tier universities. While most people think that the main purpose of top universities is to educate top students, from a societal perspective there is a very strong argument that, relative to lower-tier universities, the main role of selective universities is actually sorting, not educating. The empirical evidence for this is that students who are accepted into top universities but choose to attend lower-ranked schools on-average perform just as well economically as those who went on to top universities. Top universities serve as valuable signals to employers and other players of the caliber/innate talent of a particular student, even if lower-ranked schools could have done just as good of a job at educating that student.

On that same note, top-tier startup accelerators are the elite universities of tech ecosystems.  As tech entrepreneurship has become more widespread and the number of entrepreneurs has gone up (as the cost of starting up has gone down), tech ecosystems have become far more “noisy.” More pitches, more teams, more ideas, which overall is a great thing, but it makes it a lot harder for investors to find the investment-worthy companies. Not unlike employers sorting through millions of students.

Here in Boston, Techstars is arguably one of the most notable accelerators, although there are others here and throughout the country. MassChallenge is larger, and less selective. See Seed Accelerator Rankings for more national info.

Ask founders about the educational value of accelerators, and feedback will vary; but almost universally founders will say that the top ones pay for themselves simply from the network they open up for you by putting their stamp on your startup; just like a Harvard or MIT.

Must you attend a startup accelerator to succeed? Clearly not. The large majority of successful companies we work with never touched an accelerator. But for founders lacking strong connections to investors and other key players early on, they can dramatically accelerate a startup’s ability to find capital, advisors, etc.; and should be strongly considered.

Seed Financing Structures for Boston Startups

Background reading:

The three most common options that, from our experience as a top-tier emerging companies boutique firm, make up 95+% of seed rounds are: Equity (Preferred Stock), Convertible Notes, and SAFEs (Simple Agreement for Future Equity).

If you want a deeper dive into their pluses and minuses, read the above-linked posts. Generally speaking, stock (equity) is the most expensive and complex to do, but the main benefit is that post-closing everyone has greater certainty around ownership % and rights. The larger the round (particularly >$2MM), the more likely it is to close as a preferred stock round.

“Seed equity” is a subset of equity financing using slimmed down, highly standardized documentation that can be closed much more quickly (with lower legal fees) than a full VC-style equity round. When rounds below $1.5-2 million are to be closed as an equity round, we see Seed Equity being increasingly utilized as an option.

Aside from preferred stock described above, convertible notes and SAFEs (collectively often referred to as “convertible securities”) are the 2 dominant forms. Convertible securities are much simpler to draft (lower fees) because they defer a lot of the hard issues/negotiations to the future.  But the tradeoff is more uncertainty, and also somewhat more dilution. 

A convertible note is basically a debt (loan) instrument that, instead of actually being paid back, intends to convert into equity in the future, when a larger financing occurs; that converting financing is referred to as a “qualified financing.” It has a maturity date (typically 18 months to 3 years) that sets a deadline on the company reaching that milestone financing, or else a discussion/re-negotiation with the investors needs to happen.

SAFEs are effectively convertible notes without a maturity date; a structure invented by Y Combinator in Silicon Valley. They also convert into equity in the future, but there is no “deadline” of a maturity date, which is much more company favorable, and investor unfavorable.

recent survey of seed financing structures reveals that in California, where the volume / density of seed investment is magnitudes higher than the rest of the country, and competition among seed investors is dramatically higher, SAFEs are well on their way to becoming a dominant seed round instrument.

A key takeaway from that survey, and which I’ve emphasized several times before, is that entrepreneurs in Massachusetts, Colorado, Texas, and other ecosystems should be very careful to not assume that market conditions in their local ecosystems parallel Silicon Valley. Among convertible security seed rounds, convertible notes are far more preferred by seed investors here than SAFEs.

I don’t represent any tech investor funds, for reasons I’ve written about in How to Avoid “Captive” Company Counsel, which means I have no reason to be biased in favor of investors; and with that being said, I still think SAFEs are extraordinarily, some might say ridiculously, anti-investor and pro-company in their terms.

Convertible notes, which are the dominant convertible seed financing structure, represent a balanced trade-off. Investors get up-front stronger “pay back” protection than an equity holder would, and in exchange they get fewer voting and other rights.  Upon conversion, that stronger protection goes away, and they become stockholders.  A SAFE basically tells an investor to accept all of the downsides of convertible notes, without any of the benefits. Hope for the best.

It’s no surprise that SAFEs came from YC. Already within California, the extreme density of startup activity means competition among investors to get into top startups is more fierce, slanting the market toward companies. By being the elite of Silicon Valley at early stage, Y Combinator takes company leverage up several notches. But it’s dangerous for more “normal” companies outside of SV to take their cues from such a different environment from the one they’re operating in.

Still, as the data shows, while SAFEs are a minority structure, we still see them. But the core point here is to not get too hung up on them. We regularly see founders think they can get a SAFE closed, and then mid-way they are forced to re-do everything because a serious investor balked. Our advice is that, if you are going with convertible securities, stick to convertible notes, unless you are 100% certain that all investors you intend to raise money from will accept a SAFE.

As long as the maturity date is far off enough (2-3 years), the difference from a SAFE is minimized, and yet you’ll see far less friction from investors.