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
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.
It was shocking.
The accelerator has taken a clean YC SAFE note and has unashamedly modified key clauses to issue a horrendous document that no professional investor will push on to a founder, especially in the company’s first round. The note starts off very similar to a typical SAFE note. The template, the font, everything is the same. But then start the problems:
It offers a $50k investment for a valuation cap of $575k
Let’s start from the smaller issues. I have said this multiple times and I will say this again: Capped notes are dumb for founders. You are setting a ceiling for your price and no floor. So, you have a minimum dilution (in this case of 8 percent) and no maximum dilution (depends on the next round raise).
If you manage to raise the next round above the cap, the accelerator wins as the note converts at a lower cap. If you manage to raise the round only below the cap, the accelerator wins again by taking even more equity.
Right to increase ownership to 8% during next equity financing
As if the cap was not enough, there is a clause that gives an option for the accelerator to increase/maintain its ownership at the time of your equity financing to 8 percent. Let’s say you raise a seed equity round of US$1 million at US$3 million pre-money. Your new investor wants 25 percent. Your SAFE investor will be at 6.5 percent post conversion.
The SAFE investor further gets a right to increase ownership to 8 percent by buying more of your company. The cap table hence will likely look like 25 percent for your new investor and 8 percent for your SAFE investor. That’s 33 percent dilution without you having even gone past the product-market fit stage. Good luck finding a series A and B investor with that cap table.
4x liquidation preference
Yes, not even fu**ing kidding you. Sure, the accelerator can argue that the investment amount is small, but how do you think your next investor is going to react after seeing this? Do you think you’ll be able to negotiate your way out of a 1x participating clause with the next investor? And we all know how multiple liquidation preferences end up for the founder.
Equity financing (next round) to be of minimum $1M (YC SAFE is at $250k)
You’ll ask, why change this term? How does it matter to the accelerator when their note converts as long as the price is set? It matters because, this way, they’ll get the rights associated with a financing that is at least US$1 million in amount. These rights (pro rata, liquidation preference) are usually much stricter than what a US$200,000 to US$500,000 equity finance round would require. The accelerator now gets to enjoy the rights of a much larger investor. Remember that the cap and 8 percent pro-rata right will always protect the shareholding of the accelerator. That’s fu**ed up.
Pro-rata rights for not just this round but ALL rounds, transferrable to ANY partner
Basically, the accelerator has a lockup on 8 percent of your company henceforth and can bring in who they choose to take up that 8 percent in future rounds. A lot of early investors at later stages don’t get to enjoy pro-rata rights. If you waive it one time, you never get it back. But in this case, the accelerator in question and its affiliates will get to enjoy this 8 percent pro-rata right forever. Furthermore, the affiliate term is so loose that arguably even a mentor (including me) can get the right to participate in the 8 percent ownership if the investor is fine with that.
Right to block sale of company at a valuation less than $2M
Wow. So not only will you give back to the accelerator 4x the money if you sell too early, your sale can be blocked if it’s at too low a number.
So, let’s say your company doesn’t work out (quite likely at an accelerator stage), you can’t even take an acquihire route unless the accelerator allows it.
The whole purpose of YC SAFE was to make it easier for founders to close rounds without negotiating any terms except for valuation. Based on the twisted clauses above, I doubt that agenda is being achieved in these modified SAFE notes.
So was it the end for the company who signed this note? No. Luckily for them, investors in the next round are pushing for renegotiations of the terms of these documents. Whether or not the accelerator budges remains to be seen.
SAFE note by Accelerator Y
I then came across another accelerator which goes about touting founder friendliness. This accelerator also invests using a SAFE note. Unfortunately, I have not yet seen the exact note terms but I have managed to come across the high-level ones:
A $75k investment on uncapped SAFE convertible notes at 50% discount
Pause. Gulp. Read again.
I have never seen a 50 percent discount in any note. Usually, the number hovers between zero and 20 percent. How will an investor with a seed cheque a few months after the accelerator’s investment be fine with the accelerator walking away with half the price? I don’t know many investors who’d be OK with this (unless the accelerator helps the company perform exceptionally well in the few months it spends with the company—something I am yet to see happen in this part of the world).
If the company is unable to raise in two years, the note converts at US$1 million post-money. YC SAFE has no maturity period, so I am already starting to wonder if this is another one of those twisted SAFEs.
Converts at same class shares on a qualified raise of $200k at post-money of at least $2M
Now I am super suspicious of this clause. It says the note converts to same class shares. If that’s the case, then the founder is, in effect, handing over a 2x liquidation preference over to the accelerator.
How does “same class of shares” correspond to multiple liquidation preferences? You can read Mark Suster’s brilliant explanation here, but I’ll summarize it for you.
Let’s say the notes convert because of a US$1 million seed round at US$4 million pre-money valuation. The note thus needs to convert at a US$2 million valuation to respect the 50 percent discount. Now the way the cap table will be structured is that the accelerator will simply receive double the number of shares it would have received if it had invested in the US$4 million valuation round. Since the share class is the same as the seed equity round, assuming each equity share has a non-participating 1x liquidation preference, the accelerator gets liquidation preference for double its original investment of US$150,000 (due to the US$75,000 investment). Surprised? You should be.
Help! What should we do?
I hope you’ve woken up to the fact that our startup world is not fairyland by now. My intention is not to scare you away from accelerators but to alert you to the consequences of signing a document that you don’t thoroughly understand.
I know many founders don’t understand these intricate terms. Heck, even I didn’t understand all of this when I started my company—I learned it all the hard way. But I would recommend that if you are entering an accelerator that is pushing a SAFE note on you, follow the basic advice below before signing the dotted line.
- Know your stuff. Read Venture Deals, AVC, Feld Thoughts, Both Sides Of theTable, and be aware of what you are signing up for.
- Compare any proclaimed SAFE notes word for word with the YC SAFE notes and do not sign if you don’t understand the consequences of even a small wording change.
- Hire a good lawyer. It doesn’t cost as much as you think it does. I know of many law firms in Singapore that are trying to engage early with entrepreneurs and are willing to take a hit on their fee to build a long-term relationship with founders. A few firms that I feel are doing well for the ecosystem: Gunderson Dettmer, Simmonds Stewart, Linklaters, and Dentons.
For the accelerators
As for the accelerators, I don’t know what to say. Our firm has been associated with some of these accelerators for a long time and these terms are not what we would like to see in a deal when it comes to us.
I speak on behalf of the whole investor community when I say this: These concerns are already being voiced among investors. These accelerators are risking reputation loss with a solid possibility of investors disengaging themselves from their program.
You still want to do notes? Then do uncapped, zero discount notes and be ready to convert whenever an equity round happens. But I don’t think this makes any sense for the accelerators, as they would like to come into the company earlier than the investors to make the economics work. So, how should an accelerator invest in a company? What’s the cleanest way? In my opinion, even accelerators should just take straight-up equity.
I suggest you value every portfolio company at US$1 million post-money (unless they have raised money already in which case you need to go deeper into the negotiation). You invest US$50,000 and you get 5 percent from it, plain vanilla. Keep the terms utterly simple—no liquidation preference and no anti-dilution. A US$1 million valuation is very palatable as a valuation for a pre-seed investor coming after you, writing US$100,000 to US$300,000 cheques.
Five percent extra dilution is not enough to turn off a seed or series A investor. And 5 percent ownership is enough to make the accelerator model work.
It’s time we initiate an end to this craziness called notes. After decades of education, when founders have finally started understanding equity terms, the industry has managed to come up with another obfuscation mechanism. It’s not in the interest of anyone—neither the company’s nor the investor’s.
This article was first published on Medium.