“SAFE” Equity as an Alternative to Convertible Notes

As much as I am always inclined to mock West Coast trends, there is a recent one that I grudgingly find intriguing:  so-called “safe” equity (simple agreement for future equity), which is an alternative to convertible notes for startups seeking bridge financing to keep the lights on until they can raise substantial funds in a “real” equity round.  Y Combinator offers open source safe equity forms with some background information.  With a convertible note, the seed investor acts temporarily as a lender, with the note being converted to equity if and when the company has a qualifying equity financing.  With safe equity, the investor simply receives the right to receive preferred equity when the financing is completed, without the need to temporarily treat it as a loan.  There is no interest, maturity date, repayment terms or any other provisions that you’d associate with a debt instrument.

Safe Equity | Andrew Abramowitz, PLLCSafe promoters correctly point out that these seed investors are not ultimately seeking a debt-like steady return on their investment. As early-stage equity investors, they have more of a high risk/high reward orientation. Often with convertible notes, the negotiated terms such as interest are academic because interest will not likely be paid in the absence of a conversion.  If, for example, a startup has to pay back principal plus 8% accrued interest two years after the investment if a qualifying financing hasn’t yet occurred, in all likelihood, the startup would blow through the money in those two years and couldn’t pay back principal, let alone any amount of interest.  With safe equity, the investment is treated like an equity instrument, which reflects the intent of both parties.

The safe folks also tout the relative simplicity of the safe documentation. There is only one five-page document to be executed, and there aren’t a lot of moving parts requiring much customization. Essentially, the parties need to only agree on whether there is a cap on the valuation of the later financing for purposes of determining the number of shares to be issued to the investor, and whether the investor receives a discount on the conversion price when the later financing is completed. In fairness, convertible notes are themselves fairly simple and are used because they are themselves much simpler than VC equity documents, but safe equity seems to appropriately combine simplicity with avoiding introducing debt concepts where not intended. I haven’t yet done a safe equity deal or know anyone who has, but I wouldn’t be surprised if they gradually become accepted in my world.