Recently, there have been discussions around “seed-strapping” and whether investors should push to modify the otherwise standard terms of a Simple Agreement for Future Equity (a “SAFE”). Authored and popularized by YCombinator, a SAFE has been seen as a company-friendly alternative to a convertible promissory note for a company seeking to raise seed capital or to bridge to the company’s next equity financing round. Typically, a SAFE does not contain certain terms, such as an interest rate or maturity date, and functions similar to an interest free loan, with the investor expecting to convert at either a discount or a set post-money valuation cap during the company’s next priced round of equity financing.
Here's the rub. What happens if the startup can leverage AI and other technology to cut back on staff and development expenses, clearing a path to profitability at an early stage? Should this occur, the founders may be in a position to pay themselves a healthy salary, or even distribute profits in the form of a dividend, and consequently not feel the pressure or need to raise additional rounds of financing. Absent a contractual commitment, such as a side letter requiring the company to keep the investor informed or providing for participation in the company’s decision making via a board seat, a SAFE investor may feel they have little (or non-existent) leverage to impact the company’s trajectory. By leaving the SAFE unconverted or electing to forgo additional financing, founders seemingly maintain full control over the corporate leadership and decision making.
So will this lead to investors demanding a maturity date? For the foreseeable future, my hunch is that the majority of SAFE rounds will continue to use the standard SAFE for a couple of reasons:
Most VCs understand how a SAFE works and market trends. Thus, I can see this becoming a popular modification for a business model in which a handful of founders (or even a solo founder) could turn the company profitable in a quick manner without significant staff. While AI is changing the game in most industries, lots of startups still need sales staff, a marketing budget, and other sizable costs to achieve the market traction desired, resulting in additional capital raise efforts and the conversion of the SAFE.
The current, standard form SAFE published by YCombinator contains some protections against the unexpected non-conversion of an otherwise successful startup. First, Section 5(c) of the standard post money valuation cap SAFE stipulates that if a dividend is distributed to the company’s equity shareholders, a dividend must also be paid to the SAFE holders. Second, if the company is acquired, the investor is entitled to the greater of their investment amount, or the amount they would have been paid had the SAFE converted into shares of common stock based on the “liquidity price” (as defined in the SAFE).
The moral of the story: the standard form SAFE available online may soon have a day of reckoning in which sweeping changes are necessary, but I’m skeptical about whether we are there just yet. However, startup founders should take note of the changing landscape and opportunities AI has created, as what was originally branded as a “simple” agreement for future equity, may no longer be thought of quite so simple after all.
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