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.

A 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.