As a simple alternative to convertible promissory notes, Y Combinator developed the simple agreement for future equity, known as a “safe” instrument. In my practice, early stage seed investments still are made primarily through convertible promissory notes and forms of “light” preferred stock. However, I recently met a financially sophisticated founder that spoke highly of Y Combinator’s safe instrument, so I decided to take a closer look.
According to Y Combinator, a safe instrument is preferable to a convertible note for the following reasons, among others:
(a) A safe is not a debt instrument (it is an obligation to issue equity upon the occurrence of certain events), so there are no maturity dates and threats of insolvency. In my experience, the threat of insolvency can be a critical issue. If a startup cannot obtain sufficient financing to convert a promissory note, and the maturity date of the note passes without payment, the investor could have an easy to path to taking control of the startup, even though the startup may be financially viable. This is an extreme example, but it could be avoided by using a safe.
(b) A safe does not accrue interest. Not only does this potentially reduce the cost of capital (or the issuance of future equity), but it also eliminates the need to make additional interest calculations upon the conversion of the safe instrument.
(c) A safe should reduce the money and time spent negotiating the investment. The safe instrument has few terms to negotiate. Depending on the form of safe being used (Y Combinator provides four versions), the parties usually only will negotiate the discount rate and/or valuation cap.
Y Combinator’s safe instrument makes sense and seems to work for its intended purpose. However, if the concept is new to a seed investor, I wonder if it will take just as much time to explain and negotiate a safe as it will to just use a commonly accepted convertible note.
As a general rule, a startup should try to avoid using a valuation cap with a safe instrument or convertible note, and if a cap cannot be avoided, it should be higher than the anticipated value for the future equity financing. Most favored nation clauses also should be avoided. MFNs can become an administrative hassle, be easy to forget, and lead to incorrect capitalization reps in the future.
The safe instrument also requires the startup to provide participation rights to the investor for future financings (after the initial equity conversion). These terms should be left to the transaction documents agreed upon for the initial equity financing, which likely will provide participation rights to investors that have invested some minimum amount. Handling participation rights also can be an administrative hassle, so it makes sense to limit the number of investors who have those rights.
While the safe instrument is pretty simple, the startup still must remember to comply with applicable federal and state securities laws when using a safe.
Bob Muraski is a business attorney based in Bellingham, Washington. Photo Credit: Ryan McGuire/Gratisography.