Should Texas Founders Use SAFEs in Seed Rounds?
Nutshell: Because of the golden rule (whoever has the gold…), probably not — at least not for now.
- Y Combinator — Simple Agreement for Future Equity
- Gordon Daugherty — Reviewing the SAFE (from perspective of an Angel investor)
- SHL — SAFE: How Founders Should Paper Their Own Investments
For some time now, there have been people in the general startup ecosystem who have dreamt that, some day, investment (or at least early-stage investment) in startups will become so standardized and high velocity that there will be no negotiation on anything but the core economic terms. Fill in a few numbers, click a few buttons, and boom — you’ve closed the round. No questions about the rest of the language in the document. For the .1% of startups with so much pull that they really can dictate terms to investors (YC startups included), this is in fact the case. But then there’s the other 99.9%, much of which lies outside of Silicon Valley.
Much has been written about how SAFEs were an ‘upgrade’ on the convertible note structure, and in many ways they are. But anyone who works in technology knows that there’s a lot more to achieving mass adoption than being technically superior, including the “stickiness” of the current market leader (switching costs) and whether the marginal improvements on features make those costs a non-issue. And any good lawyer knows that when a client asks you whether she should use X or Y, she’s not paying you for theory. You dropped that sh** on your way out of law school.
This isn’t California
From the perspective of Texas founders and startups, which are the focus of SHL, the reality is that going with a SAFE investment structure is very rarely worth the cost of educating/convincing Texas angel investors on why they shouldn’t worry and just sign the dotted line. The entire point of the convertible note structure, which by far dominates Texas seed rounds, is to keep friction/negotiation to a minimum. Yes, there are many reasons why equity is technically superior, but that’s not the point. You agree on the core terms (preferably via a term sheet), draft a note, they quickly review it to make sure it looks kosher, and you close. You worry about the rest later, when you’ve built more momentum. Professional angels know what convertible notes are, and how they should look. They also know how to tweak them. In Texas, many of them still do not know what a SAFE is.
And, in truth, many Texas angels and seed VCs who do in fact know what a SAFE is simply aren’t willing to sign one. The core benefit of SAFEs to startups is that they don’t mature, and hence founders without cash can’t be forced to pay them back or liquidate. To many California investors, this isn’t a big deal, because they’ve always viewed maturity as a gun with no bullets. But Texas investors don’t see it that way. Many find comfort in knowing that, before their equity position is solidified, they have a sharp object to point at founders in case things go haywire. I’ve seen a few TX founders who rounded up one or two seasoned angels willing to sign SAFEs, only to have to re-do their seed docs when #3 or #4 showed up and required a convertible note to close. It’s not worth the hassle, unless you have your entire seed round fully subscribed and OK with SAFEs
Just Tweak Your Notes
The smarter route to dealing with the TX funding environment is to simply build mechanics into your notes that give a lot of the same benefits as SAFEs. A summary:
- Use a very low interest rate, like 1–2%. — TX angels tend to favor higher interest rates (seeing 4–8%) than west and east coast seed investors. But if you can get a very low rate, it’s more like a SAFE.
- Use a very long maturity period, like 36 months. — 18–24 months seems to have become more acceptable in TX, which is usually more than enough time to close an equity round, or at least get enough traction that your debt-holders will keep the weapons in their pockets. But if you can get 36 months, go for it.
- Have the Notes automatically convert at maturity — This gets you as close to a SAFE as possible, and we’ve seen many angels accept it. If you run out of time and hit maturity, either the angels extend, or the Notes convert, often into common stock at either a pre-determined valuation (like the valuation cap, or a discount on the cap), or at a valuation determined at the conversion time.
How successful you’ll be at getting the above is just a matter of bargaining power and the composition of your investor base. Austin investors, who think more (but not completely) like California investors, tend to be more OK with these kinds of terms. In Houston, Dallas, or San Antonio, you’ll likely get a bit more pushback. But that pushback will almost certainly be less than what you’d get from handing someone a SAFE.
Closing Summary: There isn’t, and likely will never be, a national standard for seed investment documentation. Every ecosystem has its nuances, and working with people who know those nuances will save you a lot of headaches. In Texas, the convertible note, however suboptimal, reigns supreme. Respect that reality, and work within it to get what you want.
Originally published at Silicon Hills Lawyer.