Some startup investors might think that the biggest innovation to emerge from Y Combinator in 2013 was DoorDash — particularly those investors who participated in the company’s early funding rounds and walked away with impressive returns on their investments. But for most startup investors, the biggest innovation Y Combinator gave the world this year was its “simple future equity arrangement,” or SAFE.
SAFEs, like convertible debentures, offer a means of incentivizing early investors to de-risk an emerging company by giving them the opportunity to buy into the issuer’s next equity financing at a discount. However, SAFEs aren’t debt and don’t have a maturity date or interest rate, limiting some of the leverage investors can pull should the startup go sideways.
While SAFEs can benefit investors by reducing transaction costs and legal fees, they can pose problems for two main reasons. First, they offer no guarantee that the investment will convert to equity, as it is possible that a startup will never achieve the conversion triggers outlined in the SAFE, such as: B. Selling stock in a future price round or selling the company SAFE investors with little to no recourse if conversion events are not met. Second, SAFEs are rarely negotiated and the process of amending them when circumstances change for the issuing company can be difficult in practice.
For these reasons, SAFEs can be risky for investors, particularly when investing early in a company that’s struggling to achieve the hockey stick growth that would prompt future price rounds with exponentially higher valuations, a sale, or an IPO. At the other end of the spectrum, it is possible for a startup to perform exceptionally well in the marketplace without engaging in activities that would trigger a stock conversion, giving SAFE holders an economic position but none of the voting rights associated with stock ownership. Because of these risks, if the only way to invest early in an attractive startup is with a SAFE, investors must carefully review the startup to determine if they can minimize the risk they are taking by investing in it. With the caveat that investors will never eliminate all of the risks they face when investing in an early-stage startup via a SAFE, examining the following five factors can help investors determine if they’re making a safer bet.
What kind of products or services does the startup have and what industry is it in?
The best starting point for this analysis is the most obvious question: what does the startup do and what industry is it in? It is critical to determine whether the Company operates in an industry where a conversion event and an ultimately favorable outcome are not only possible but probable under current market conditions.
What is the startup’s leadership team like?
Some investors claim they don’t invest in companies, but in founders. Even if investors don’t share this belief, they still need to evaluate the founder(s) and executive team of the company they intend to invest in through a SAFE.
Has the leadership team had multiple rounds of funding or profitable exits in the past and does it know the game plan to pull them off again? If not, has the team worked for founders and companies that have, and might be able to replicate those strategies and tactics?
How strong is the leadership team’s vision for the company and their work ethic? What do the education, work history, and hobbies and interests of the leadership team say about the leaders and their ability to grow a business? Are they showing signs that they will do everything in their power to win the starting game? Or do they have a relaxed approach to the business that suggests they are not motivated to build the company to a size that would present opportunities for a conversion event to investors who have signed SAFEs?
Who are the company’s other investors, if any?
SAFE’s Y Combinator form is a self-contained document that does not require the issuing company to state whether there are other investors or how much other investors have invested. SAFE investors should confirm the amount that other investors have invested to avoid investing in an undercapitalized company.
Of course, if there are no other investors, that raises additional questions. Isn’t there one because other investors either didn’t want to invest through a SAFE or were generally concerned about investing in the startup? In this scenario, investors should consider requiring the company to meet a certain total investment threshold before investing their money through a SAFE.
Have there been previous investment rounds or other signed SAFEs?
While SAFEs are typically deployed early in a startup’s life, investors may have the opportunity to jump into a SAFE after multiple rounds of funding. If that’s the case, investors should determine what those previous funding rounds say about the startup’s past and future.
Are the earlier rounds a sign that the startup was using up money too quickly, with too little revenue to continue without an infusion of much-needed cash? Or do these rounds show investors’ belief in the leadership team and the startup’s mission?
Were the previous rounds of funding also conducted through SAFEs or through more traditional means of raising capital? If they went through the latter, why are investors being offered a SAFE now?
Are the potential investors qualified to evaluate these factors?
Finally, given the potential of entering into a SAFE with a startup, potential investors must determine whether they and/or their peers are even qualified to properly vet the startup. Some companies want to delve into startup investing, but their “scout” teams are unfamiliar with the process and don’t know what to look for. Even if they know what to look for, would these teams be able to find answers? Can they ask the right questions about a startup’s offering, industry, and leadership team? Can they figure out the economic and market conditions that are likely to affect the startup? Do they know how to locate previous investments and other investors in the startup? In other words, can potential investors perform the necessary due diligence to determine if they should invest in a startup through a SAFE?
If the answer to these questions is no, but the investment opportunity seems promising, it’s not time to give up – it’s time to call for help!
Make a SAFE bet safer
All investments involve risk for investors making those investments, and while SAFEs can be quickly documented and negotiated, they are not without risk. As SAFEs have become one of the predominant forms of early financing vehicles for startups over the past decade, they will be inevitable for investors interested in startups. While no investment is truly risk-free, potential investors could make their SAFE bet a little safer by evaluating the above five factors as part of their due diligence when investing in a startup via a SAFE.