These shocking hidden terms of ‘SAFE’ notes can screw up your startup

Photo credit: John-Mark Kuznietsov.

If you have heard me speak publicly or if you follow my blog, you’re likely familiar with my hatred of convertible notes. Lately, though, I have come across some notes that founders are signing with well-known accelerators, further strengthening my belief that notes are evil. I’ve decided not to ignore these issues, as most investors in the region are doing, and speak up openly about them. In this post, I’ll refrain from giving out names. If you’d like to learn more, feel free to reach out to me personally on LinkedIn. I’ll respond.

As I mentioned in my earlier blog post, at GREE, we prefer to sign on equity rather than notes due to multiple reasons. We have signed notes in the past and will continue to do so in the future when the founder is insistent on doing things this way. But we will definitely encourage each company we are investing in to consider the demerits of signing on a note.

The biggest demerit for the founder, in this case, is the fact that a capped note hands over a full ratchet anti-dilution clause to the investor. The biggest demerit for the investor is that we never really know how much we own in the company, making life difficult for us especially if the company issues multilayered notes.

But this post is not about generic notes. I want to discuss Simple Agreement for Future Equity (SAFE) notes that are currently being issued by two well-known accelerators in the region. One of these notes, modeled on the famous Y Combinator (YC)  SAFE note, has been twisted to form a convoluted and extremely founder-unfriendly agreement. What’s worse still is that the notes are being presented as a founder-friendly agreement, and some unfortunate entrepreneurs are falling into the trap.

YC SAFE notes

I will not go into the details of the famous notes issued by Y Combinator (there is enough material on the internet for you to understand these). Suffice to say that YC had very good intentions while issuing these notes. The notes they created help in saving founders from negotiating complex control and pricing terms too early in their company while protecting them from any hidden clauses that might lurk in documents served by an ill-intentioned investor.

However, investors in the US are also starting to voice their opinions on how the YC SAFE notes are doing more harm than good. While YC’s intentions may be good, there is a case to be made that the notes are causing harm to at least a few companies.

Regardless of whether the notes work for or against the founder in the long run, one thing most founders (and even investors) don’t realize is that YC takes equity in the company first and then issues a note.

We know this because of our investment in Saleswhale (a YC company) and because we have firsthand access to all the documents there. Here is how the process works for YC (at least from my knowledge of investing in one YC-backed company).

• Issue US$20,000 for 6.06 percent equity
• Issue US$100,000 on a YC SAFE note at a US$10 million price (In this particular SAFE, the cap of US$10 million is the conversion price and even if the future equity round happens at a valuation less than that, the note will still convert at US$10 million. Thus, this is a convertible note where the price is exactly US$10 million regardless of next round valuation.)

While every other accelerator, angel investor, or founder is raising/investing on a SAFE note similar to what they say YC uses, what they do not realize is that YC itself is actually taking equity and is using the note only for protecting its interest for the next round. Figure that one out for me.

SAFE note by Accelerator X

“SAFE” issued by Accelerator X.

Then, we come to the point of this post. While conducting due diligence on a company that recently graduated from a well-known accelerator in the region, I managed to see the note that the founder signed with the accelerator a few months ago.

SAFE note by Accelerator Y

Help! What should we do?

For the accelerators