Some startup investors might think the biggest innovation to come out of Y Combinator in 2013 was DoorDash — especially investors who participated in the company’s early funding rounds and walked away with impressive returns. But for most startup investors, the biggest innovation Y Combinator gave the world that year was the “simple deal for future equity,” or SAFE.
SAFEs, like convertible debt, offer a way to incentivize early investors to de-risk an emerging company by providing them with a way to purchase the issuer’s next equity financing at a discount. However, SAFEs are not debt and have no maturity date or interest rate, which limits some of the leverage investors can use in case the startup goes bad.
Although SAFEs can benefit investors by reducing transaction costs and legal fees, they can cause problems for two main reasons. First, they provide no guarantee that the investment will convert to equity, as a startup may never reach the conversion triggers outlined in the SAFE, such as selling shares in a future price turn or a sale of the business, leaving SAFE Investors with little or no recourse if conversion events are not met. Second, SAFEs are rarely traded and the process of changing them when circumstances change for the issuing company can be practically difficult.
For these reasons, SAFEs can be risky for investors, especially when investing early in a company struggling to achieve the hockey stick growth that would usher in future price rounds at exponentially higher valuations, a sell-off. or an initial public offering. At the other end of the spectrum, it is possible for a startup to do exceptionally well in the market without engaging in activities that would trigger a stock conversion, leaving SAFE holders with an economic position but without any of the rights. of votes associated with the shareholding. . Because of these risks, when the only opportunity for investors to invest early in an attractive startup is through a SAFE, they will need to carefully review the startup to determine if they can minimize the risk they are taking on 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 through SAFE, reviewing the following five factors can help investors determine whether they make a safer bet.
What is the nature of the startup’s products or services, and what industry does it belong to?
The best place to start this analysis is with the most obvious question: What does the startup do and what industry is it in? It is essential to determine whether the company is in an industry where a conversion event and an ultimate favorable outcome are not only possible, but also likely under current market conditions.
How is the management team of the startup?
Some investors claim that they don’t invest in companies, they invest in founders. Even if investors do not subscribe to this belief, they should evaluate the founder(s) and management team of the company they are considering investing in through a SAFE.
Has the management team had multiple funding rounds or profitable exits in the past, and do they know the game plan for pulling them off again? If not, has the team worked for founders and companies that have, and might they 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 leadership team’s education, work history, hobbies, and interests say about leaders and their abilities to grow a business? Are they showing signs that they will do everything in their power to win the starter game? Or do they have a casual approach to business that suggests they are not motivated to build the business to a size that would provide opportunities for a conversion event for its investors who signed SAFEs?
Who are the other investors in the company, if any?
SAFE’s Form Y Combinator is a stand-alone document that does not require the issuing company to identify whether there are other investors or how much other investors have invested. SAFE investors should confirm how much other investors have invested to avoid investing in an undercapitalized company.
Of course, if there are no other investors, that raises additional questions. Are there none because other investors didn’t want to invest through a SAFE or had reservations about investing in the startup in general? In this scenario, investors should consider requiring the company to meet a certain overall investment threshold before committing their money through a SAFE.
Have there been previous investment rounds or other SAFEs signed?
Although SAFEs are typically used early in a startup’s life, investors may have the option of entering into a SAFE after several rounds of funding. If so, investors need to figure out what those previous funding rounds say about the startup’s past and future.
Are the previous rounds a sign that the startup has exhausted its cash too quickly, with too little revenue, to continue operating without an infusion of desperately needed cash? Or do these rounds show investor belief in the startup’s leadership team and mission?
Were early funding rounds also done through SAFE or through more traditional means of raising capital? If they’ve been there, why are investors being offered SAFE now?
Are potential investors qualified to assess these factors?
Finally, faced with the possibility of entering into a SAFE with a startup, potential investors must determine whether they and/or their colleagues are even qualified to properly monitor the startup. Some companies want to get into startup investing, but their scouting teams aren’t familiar with the process and wouldn’t know what to look for. Even when they knew 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 management team? Can they determine economic and market conditions that may affect the startup? Do they know how to find previous investments and other investors in the startup? In other words, can potential investors do the necessary due diligence to determine whether to invest in a startup through a SAFE?
If the answer to these questions is “no,” but the investment opportunity looks promising, now is not the time to give up — it’s time to call for help!
Make a SAFE bet safer
All investments carry risk for the investors making those investments, and although SAFEs can be documented and traded quickly, they are not without risk. Because SAFEs have become one of the predominant forms of early-stage funding vehicles for fundraising startups over the past decade, they will be a go-to for investors interested in the startup space. While no investment is truly risk-free, by evaluating the above five factors as part of their due diligence for investing in a startup through a SAFE, potential investors could make their SAFE bet a little safer.