Market Forces Will Determine Fate of New Start-up Funding Vehicle
We are in early days for SAFEs – Simple Agreements for Future Equity, the newest method by which investors can finance start-ups they view as The Next Big Thing – but even with relatively few precincts reporting in, the voting patterns are starting to become clear.
Generally viewing SAFEs favorably are the earliest-stage investors that are less institutional – friends and family, and some angels – plus issuing companies and their entrepreneurial founders, and many in the startup game with strong ties to the West Coast, where innovation is generally in favor and where SAFEs began.
More skeptical at this point are more institutional investors – venture capitalists, most notably – as well as East Coasters, who tend to be a bit more traditional than their West Coast cousins.
Both of these trend lines, of course, are subject to change over time, as SAFEs get vetted, probed, poked and examined. That process began several weeks ago, when my law firm, McCarter & English, and more specifically our Venture Capital/Early Stage practice group, issued an alert that SAFEs seemed to be headed east, with our firm working on two such transactions, one each in New York City and Canada.
The process continued – in earnest – at the well-attended teq.Konnect 2015 Winter Meetup at our firm’s office in East Brunswick. There, approximately 100 entrepreneurs and investors exchanged visceral reactions, observations, thoughts and ideas with SAFE-savvy professionals – Daniel McGrath of Maloy Risk Services (insurance); Chip and Jim Parmele of Parmele McDermott and Thomas (insurance and venture capital limited partner investors); Kevin Pianko, CPA, partner with WeiserMazars (accounting); and me – on whether SAFEs will get traction in New York and New Jersey and, if so, when and under what circumstances.
More about entrepreneurs’ and investors’ reactions to SAFEs shortly, but first, a bit about SAFEs themselves.
There is no doubt that the primary concern for fledgling companies is early-round, seed-stage finance. (When we asked at teq.Konnect for entrepreneurs to raise a hand if they are seeking investors and early-stage financing, nearly every hand in the room went up.) Related concerns include keeping transactional costs and professional fees to a bare minimum. SAFEs, which allow investors to finance companies today with the promise of equity participation at some point in the future, speak to those concerns. Here’s why:
* As standardized, one-document securities, SAFEs are easy, fast and cheap to structure. The average SAFE document runs about four pages, and professionals’ charges are a fraction of those to negotiate, prepare and review convertible note financings.
* They entail relatively little negotiation, usually nothing more than a discount rate and/or capped conversion price.
* They more accurately reflect the realities of early-stage company valuations, investment risks and rewards, to the benefit of the company and prospective backers.
* They are transparently an equity play – not an equity play disguised as a debt instrument. After all, savvy investors are not seeking a 6- to 10-percent interest rate, but rather an equity stake when the issuing company succeeds and attracts later-round capital. Like a convertible note, a SAFE, by its terms, outlines when it converts to equity; unlike a note, the conversion is triggered without a threshold amount of capital the company must raise.
Those are among the reasons that the California-based seed-financing powerhouse Y Combinator is actively utilizing and advocating for SAFEs. So why are more institutional investors, such as venture capitalists, remaining hesitant and, for the time being, on the sidelines? A decidedly unscientific poll, conducted before the meetup by our teq.Konnect panelists, revealed several reasons for skepticism.
Institutional investors seem to want more protections than a simple document with virtually no protection for investors provides. Among that crowd, there is a general unease with anything so new and relatively untested. Some view SAFEs as a not-ready-for-prime-time vehicle, to be used sparingly and only as a last resort. The objections – legitimate though they may be in some circumstances – strike me as more subjective than the objective benefit that SAFEs boosters point to. Even so, while convertible notes are hardly a panacea, they do offer some additional investor protection in the event the company does not succeed but there remains some value in the technology or solution. At least then, the convertible noteholders stand ahead of the equity investors.
The most telling response to our unscientific poll – and it was repeated a number of times, in a number of responses, in a number of ways – was the overriding belief among skeptical VCs that if an issuing company is perceived as hot enough, even naysayers will consider participating. In other words, market forces, as usual, will drive the issue.
As with any business decision, there are a number of factors to consider; deals are often a series of tradeoffs and compromises downward from a participant’s ideal. So for investors who would prefer convertible note financings or some other investing mechanism, a strong desire to participate and own a piece of an up-and-coming company may trump that squeamishness and lead them to agree to SAFEs. And for entrepreneurs who have discovered or developed hot new ideas, packaged them well, and presented them cleverly to the investment community, they may see SAFEs as a logical, effective, inexpensive way to raise badly needed capital.
We predict that SAFEs, given their pros and cons, most likely will be used primarily in pre-institutional rounds in which the investors, usually angels, high net worth individuals or technology company leaders and entrepreneurs, are eager to participate and willing to assume higher levels of risk, while most angel funds, venture capitalists, corporate partners and other institutional investors will continue to prefer priced equity rounds and the additional rights, protections, preferences, and designations they offer.