As the saying goes, where you stand on an issue often rests on where you sit. Translated into startup law and finance, your views on how to approach fundraising are often heavily influenced by where your company and your investors are located. As a startup lawyer at Egan Nelson LLP (E/N), a leading boutique firm focused on tech markets outside of Silicon Valley — like Austin, Seattle, NYC, Denver, etc. — that’s the perspective I bring to this post.
At a very high level, the three most common financing structures for startup seed rounds across the country are (i) equity, (ii) convertible notes and (iii) SAFEs. Others have come and gone, but never really achieved much traction. As to which one is appropriate for your company’s early funding, there’s no universal answer. It depends heavily on the context; not just of what the company’s own priorities and leverage are, but also the expectations and norms of the investors you plan to approach. Maintaining flexibility, and not getting bogged down by a rigid one-approach-fits-all mindset is important in that regard.
Here’s the TL;DR: When a client comes to me suggesting they might do a SAFE round, my first piece of advice is that a convertible note with a long maturity (three years) and low interest rate (like 2 percent or 3 percent) will give them functionally the same thing — while minimizing friction with more traditional investors.
Why? Read on for more details.
Convertible notes for smaller seed rounds
Convertible securities (convertible notes and SAFEs) are often favored, particularly for smaller rounds (less than $2 million), for their simplicity and speed to close. They defer a lot of the heavier terms and negotiation to a later date. The dominant convertible security (when equity is not being issued) across the country for seed funding is a convertible note, which is basically a debt instrument that is intended to convert into equity in the future when you close a larger round (usually a Series A). The note’s conversion economics are more favorable than what Series A investors pay, due to the greater risk the seed investors took on.
In most cases these days, seed convertible notes have only a handful of flexible variables (conversion price discount, valuation cap, interest rate, qualified financing threshold and maturity date) to nail down with investors, and are closed on a single document. In my experience, it’s rare to have only a conversion discount, and not a valuation cap, unless it isn’t really part of a full seed round and is instead serving as a “bridge” to an equity round intended to occur very quickly (in a few months max). Having an uncapped convertible note sit out there potentially for years (as a company’s valuation increases) is just a terrible deal for seed investors, which is why it’s increasingly rare. Even companies with significant leverage that we’ve worked with tend to include some form of valuation cap, out of a sense of fairness to investors.
As for “templates” to use for convertible notes, most law firms with specialization in this space have their own forms that will work perfectly fine and have any future “gotchas” addressed in the details. For companies working without respected counsel and with almost no legal budget, Clerky is a safe option; with the obvious trade-off being that the automation introduces inflexibility. As for what the right specifics are for the limited number of convertible note variables, it’s all over the map, depending on the company’s unique context, so work with experienced advisors on that if you can. Extra Crunch has been helping in that regard by posting profiles of vetted lawyers.
SAFEs (created by Y Combinator) have emerged as a possible alternative to convertible notes. Like any instrument, they have their pluses and minuses, with the minuses having increased significantly as of late based on changes YC has been promoting. Understanding why convertible notes should typically be favored over SAFEs requires a bit of a dive into seed round history. We’ll go into that below.
A brief history of seed instruments
Y Combinator made a splash years ago when it introduced the Simple Agreement for Future Equity (SAFE). Distilled into simple terms, the SAFE is effectively a convertible note without a maturity date or interest. At the time it was announced, the SAFE was about the most company-friendly, and investor-unfriendly, startup financing instrument ever introduced. This fact was not lost on many early-stage investors across the country.
By the time SAFEs were introduced, most convertible note rounds that we were seeing had become significantly simplified, down to a single document (like SAFEs), and with minimal rights beyond conversion into equity in the future at economics more favorable than the Series A new money. So when SAFEs were introduced, the structure looked quite familiar. In fact, it looked almost exactly like typical convertible notes, just without interest or maturity, and with a new (clever) name.
Maturity about maturity
In seed convertible note deals, the combination of totally minimal rights upfront with a “deadline” of sorts for the company to convert the notes (the maturity date) represented a kind of balanced deal between startups and seed investors. Typically at seed stage, the company is still trying to “find itself.” They’ve got a product that is clearly promising, but the ability to move fast and iterate on the business is seen by all sides (founders and money) as strategically important at the very early stages. This explains the logical trend toward, in many cases, minimizing any heavy restrictions and infrastructure (like a large board, covenants, etc.) that could get in the way of the startups’ ability to move quickly and find product-market fit — at which point you can layer on a more formal governance structure with a Series A round.
To many angels and seed funds, the maturity date on a convertible note was a kind of insurance policy for giving startups their money, while accepting virtually no rights or control upfront. Achieve traction and raise a Series A that the notes convert into (with more substantial rights), as planned, and everything goes smoothly. But take too long, and the maturity date will serve as a forcing function for a discussion with investors, and a re-calibration if necessary. Along with maturity, interest also served to give a sense of “urgency” to get the notes converted to end interest accrual.
While actually calling the debt at maturity does happen in rare instances, in the vast majority of cases when a maturity date is hit, investors and founders have a candid discussion, and choose to modify the terms to give the company a bit more breathing room to make things happen. Most convertible debtholders have nothing to gain in calling debt on an early-stage startup with little to no hard assets to liquidate. Good startup lawyers also have a variety of options for “softening” the impact of maturity even further, with minimal drafting time (like auto-extensions if certain conditions are met, as just one example).
SAFEs not as popular outside of California
From the perspective of many (not all) early-stage investors, the introduction of the SAFE, with the removal of maturity and interest, upset this “balanced” deal. The SAFE kept in place the minimal rights for investors, while eliminating their “insurance policy” of a maturity date. In other words, it told investors: “Thank you for your money. We’ll let you know how it goes, whenever we decide to. Just trust us.” Many high-integrity investors with no intent or desire to use maturity to hurt companies (and a record to prove it) felt that the SAFE instrument was, basically, arrogant and unfair. Few people were surprised when SAFEs resulted in a boom of serial seed rounds, as very fast-moving entrepreneurs, often enabled by “spray and pray” seed investors, kept raising more and more SAFEs, deferring more fully developed (and accountable) deals into the distant future.
Speaking as a lawyer who deliberately represents only companies and avoids dependencies / conflicts with investors — if you’re interested in why, read here — my unbiased opinion has been that many investors were justified in their negative reaction to SAFEs. Why shouldn’t investors have at least some reasonable method for ensuring accountability? As long as maturity is long enough to give founders sufficient breathing room to achieve milestones with the seed money, a two to three-year maturity (what most of our convertible notes have) served perfectly fine and kept everyone relatively happy — despite the fact that investors were getting basically zero rights until conversion or maturity.
This reality of how many investors view SAFEs unfavorably (not without reason) is reflected in my experience closing deals outside of SV, and also by broad survey data. In California, SAFE adoption has grown very fast, although it’s likely still outnumbered by convertible notes. Outside of California, where angel and seed investors often think quite differently, its usage has grown, but far more slowly, with convertible notes remaining the dominant convertible security by far.
Convertible notes may be “safer” long-term
When a client comes to me suggesting they might do a SAFE round (often after doing some Googling), my first piece of advice is that a convertible note with a long maturity (three years) and low interest rate (like 2 or 3 percent) will give them functionally the same thing, while minimizing friction with more traditional investors. Too often founders will start by raising a few checks on a SAFE, only to find that a later key check won’t close on it. Then they’re typically required to go back and convert the full round into convertible notes (or equity), with legal costs being far higher than if they’d just slowed down and thought things through a bit more upfront.
The last thing you want to do is actually have a conversation with early investors about why two to three years isn’t enough time for you to make things happen, and even give you some buffer for pivots and road bumps. That’s a terrible signal to give. Why introduce even the potential for friction in closing your seed round if the money on the table is willing to give you, as an example, 2-3 percent interest and 24-36 months for a maturity date? The upside to doing a SAFE over a convertible note, in that context, just isn’t there, especially if you’re raising from respected investors with good reputations.
In short, convertible notes with low interest and lengthy maturity are typically far “safer” to use than SAFEs, unless you are 100 percent positive every single check you need will close on a SAFE. The legal fee differences between convertible notes and SAFEs are also usually negligible if you’re working with investors (and lawyers) who know the game. We’ll still close on a SAFE when the client has thought it through and made the decision, but it shouldn’t be a default.
YC’s changing approach
Given recent announcements from YC regarding fundraising instruments, my impression is that they’re acknowledging the excesses of the original SAFE. Their recent modification to the SAFE instrument, by having it convert using a post-money calculation (instead of the conventional pre-money approach) is a significant move toward making SAFEs less company-friendly. Of all the possible approaches for providing greater “certainty” around how convertible notes and SAFEs convert, the post-money approach represents one of the most aggressively investor-friendly choices from an economics standpoint — even more so than doing a straight equity round. The views of practitioners in this space about YC’s post-money approach are very mixed, and the jury is therefore still out as to how much adoption it’ll see.
Couple the move toward post-money SAFEs with YC’s new (so-called) “Standard and Clean” Series A term sheet, which from my review is also a very investor-friendly (and company-unfriendly) template, and one would be reasonable in concluding that YC’s philosophy on fundraising and “founder friendliness” is most certainly shifting. This shift warrants more caution from entrepreneurs in approaching YC’s favored documents, and raises the stakes in how you choose your advisors to help you negotiate those documents.
Between a lengthy maturity date on a streamlined pre-money convertible note versus the new SAFE’s post-money economics, I’d typically advise startups to choose maturity (with a convertible note). Harsher economics are far worse than a reasonable maturity date. If “certainty” around ownership is such a top priority to your investors, consider equity.
Keep “seed equity” in mind
The reason convertible securities (like convertible notes and SAFEs) are typically favored over full equity rounds is speed and cost. Legal fees on a convertible round can be dramatically lower than a Series A deal. From the deals we see, the breakdown is usually: (a) if it’s below $1 million, you’re likely doing convertible notes or SAFEs, (b) if it’s above $2 million, you’re likely doing a full Series A-style deal, and (c) between $1 million and $2 million is where the decision gets more complex. That’s speaking for non-SV norms.
Seed equity represents a useful middle ground to keep in mind, with “Series Seed” and “Series AA” docs being the most common structures. Seed equity docs are simplified, shorter versions of Series A-style docs. Years ago, Techstars released template forms upon which a number of firms have since improved. We use them often.
While certainly more expensive to close on than a convertible security, seed equity fees are typically a third to half of a full Series A structure — and also much faster to draft and close. Not all investors will accept them — much like all investors won’t accept SAFEs — but it’s an option to consider. As with all instruments, there are pluses and minuses. Work with trusted advisors to arrive at the right answer for your context.
Stay flexible, and be well-advised
To bring this post to a close, the impression given by certain ecosystem voices that seed rounds have become completely “standardized” into one or two simple templates is not an accurate representation of reality, even among “true” angels and seed funds doing many tech deals a year.
In fact, “this is standard” and “let’s close this deal fast” rhetoric has become an unfortunately common way to get inexperienced teams to not think through the full diversity of flexible options, and not spend time with trustworthy, experienced advisors (including legal counsel without conflicts of interest) to ensure the right choices are made for high-stakes deals. “Standard” is in the eye of the beholder. Some beholders are “owned” by the money.
Long-term, a poor choice in a seed fundraising structure can have multi-million-dollar implications, and dramatic differences in resulting governance power. Also, serial investors (including accelerators) know all the subtle ins-and-outs of these structures and how they play out over time, while inexperienced entrepreneurs and early employees (early common stockholders) don’t, the latter of which rely on trusted advisors to level the playing field. Seed rounds are absolutely no time to reinvent wheels, but they’re still sufficiently high-stakes, complex and diverse that startups should be very cautious with anyone suggesting that it’s as simple as choosing chocolate or vanilla ice cream, and then closing quickly.
Maybe the constant push to “close fast” and use this or that so-called “standard” template is really a noble attempt to save startup teams some money on legal fees. Sure, it’s possible. Or maybe it’s, at least in some contexts, a way to use their inexperience against them. In a high-stakes game of the inexperienced versus the highly experienced, who really benefits by moving very fast? The right answer to all of this is, of course, “it depends.” That’s also the right answer for what seed structure you should use.