Announcing the Safe, a Replacement for Convertible Notes

I guess I'm not asking about the implied cap from the future conversion into preferred, but the EV stemming from the mere ownership of, say, a million dollars by the company. We use restricted stock that vests by lapsing a right to repurchase, since it's cheaper for the employee (no cost associated with the option itself) and it starts the long term cap gains clock right away. This makes them a direct shareholder, though, and if the only stock outstanding in the early days is common, it seems like the cash-related EV would have to be attributed to it, right?

A few thoughts (apologies up front for the somewhat longish technical aspects of the discussion):

1. YC has once again managed to innovate in fascinating ways that help promote startups. And, it should be said, the legal work behind formulating this instrument called a "safe" is both sophisticated and commendable. It is at once simple and subtle and it covers a lot of nuanced legal technicalities that must have required some pretty careful thought to get right. The result should be extremely helpful to startups and their founders and gives founders one more powerful tool to use for their most important funding needs.

2. The safe enables founders to raise early-stage funds without having to do a premature equity round. The tax laws create problems for startups and their founders if they raise money from outside investors too early in exchange for stock grants. This typically winds up putting an unacceptably high price on the common stock, creating tax risks for all concerned and also lessening the value of incentives that can be offered to key people going forward (fuller thoughts here: https://news.ycombinator.com/item?id=6849648). If first outside funding is to be deferred, though, the perennial challenge becomes how to fund the interim process.

3. The convertible note meets this need by combining the attributes of debt and equity instruments. The investor loans funds to the company and the company signs a note promising to repay the principal with interest. If, however, the company can do a qualified funding before the note matures, the debt converts into preferred-stock equity on the terms struck with the equity investors at first funding, usually with a price discount, sometimes with a price cap, and typically with merger-premium protection for the converting noteholders for the added risk they take in being early in the game when risks are at their highest. In that case, the debt vanishes and the noteholder becomes an equity holder and everybody wins in terms of optimal positioning of their respective stakes in the venture: founders have gotten their cheap stock that they can hold until a liquidity event, at which time they can sell typically for long-term capital gains and with no intervening taxes to pay; noteholders have gotten their equity stakes with all protections and with no-less-favorable pricing than that offered to the preferred stock investors who presumably have negotiated a good, arms-length deal for themselves; the company avoids a too-early high repricing of its stock so it can continue to offer good incentives to new team members as they join; and the company does not usually have to fool with 409A valuations or with other strings and formalities attending the bringing in of investors via equity rounds. All of which is great. But debt is debt. And, unless and until a first funding occurs, it must be carried on the balance sheet as debt. Debt also carries interest. And when it comes due, the noteholder has a legal right to sue for its repayment if it is not paid. If the noteholder wants to extend the term, a series of formalities are required to do so and, in their absence, the parties stand at legal risk.

4. The convertible note supplanted an earlier form of convertible note used many years back by which individual investors would see startups as being much akin to small businesses and would loan the money to the venture with the primary aim of making a good interest return on their investment. This might be called an "optional convertible" note and I remember doing many of these back in the day as a lawyer. That sort of note saw the conversion right as a privilege belonging strictly to the noteholder. In the normal course, the debt was expected to be repaid with interest. It might even be secured with the company's assets as collateral. It might be personally guaranteed by the founders. These were all the normal lender protections expected by those who had the investment mindset of that day. The conversion was there as an added perk only: if the company happened to do very well, then the investor could forget about the debt as such and could instead elect to convert it into equity (very typically common stock and at a price set up front, at the time the note was signed). So, for instance, an investor would loan $50K at 10% interest at a time when the company had little value but could elect to convert at, say, $.50/sh at any time in the sole discretion of the investor. The mindset in this era, then, was primarily upon the debt as debt but with an equity kicker to cover long-shot cases.

5. This mindset all changed during the bubble era, when convertible notes came in to help solve the early-stage funding problem. With its "forced conversion" element, it not only combined the elements of debt and equity but did so with equity being the main focus of the investor. Few if any investors by that time were primarily interested in being repaid the debt owed by the company. The equity upside motivated the investment and the debt came to be seen as added insurance just in case the venture did not pan out as hoped. Because of its force-conversion attribute, it was regarded under law as a "security," which basically means that the investor casts his lot primarily with the managerial efforts of company management while forgoing legal rights intended to protect a debt-type investment.

6. The safe seeks to confer the benefits of a convertible instrument without carrying with it the baggage of debt. It would thus be regarded under law as a "convertible security." That means the debt protections largely go away for the investor and the investor places his bet almost entirely on the efforts of company management. Thus, if this instrument achieves widespread adoption, the investor mindset will have evolved over the years from "loan with equity kicker" (old form of optional convertible note) to a convertible-note-style security instrument with true loan features (today’s conventional convertible note) to a pure convertible security (the safe).

7. I think it should work beautifully in the YC context. Whether it will achieve widespread acceptance or not will depend on investor expectations. I am not so sure. After all, the earliest investors do take the biggest risks. Is it enough to compensate them with a discounted price or price cap at conversion? If I were to guess, I would say that it is enough in the YC context. But it will be interesting to see if investors generally come to feel this way. In effect, the safe does leave founders saying to early investors, "Give us your money and but wait on getting your equity: if it goes well, you get equity; if it does not, you get nothing and you have almost no rights." Apart from a very vibrant context such as YC, where investor demand is already high, I am not sure how well that will sell when all the investor needs to say in response is, "how about us just doing a convertible note instead." I personally believe that for the general range of cases the pull toward a conventional convertible note will be very strong, and founders will have real difficulty convincing investors why they should forego the benefits of a convertible note in favor of a convertible security where the only advantages to the latter lie strictly with the company. But who knows? The YC magic has worked before to transform investor mindsets (I vividly remember how horribly out of favor convertible notes were just a short while back) and it may work this time too. Whether it does or not, we can all be thankful that YC is doing great and innovative things to add to the vibrancy of the startup world, and the safe is one more thing to add to the list (kudos to their excellent lawyers as well).

I think with this idea you end up back at the note concept; what you are proposing sounds more like a loan / debt to me (if I understand you correctly?). The purpose of the safe, anyway, is to turn investors into stockholders at some point.

Convertible notes are common across all companies raising early (seed) money, even ones outside YC. I don't know the landscape now, but the last time I was involved in raising money (2011 Q2), convertible notes were the presumptive default for that type of raise. Angel investors did not care at all and VCs sort-of cared, but the amount of money was so small for them that things like pro-rata participation rights were vastly more important.

> (3) no interest = less equity at conversion

This will be taken care by the market via the caps put on the Safe.