Why Now Is Not the Time for SAFES and Convertible Notes | First Avenue Ventures
Pre-COVID-19, I told someone that I did not like SAFEs and convertible notes. I wish I could find that person now; I would assume a little more credence. Regardless, for what it’s worth, I didn’t like convertible debt or SAFEs before COVID-19. Now, I really don’t like them.
I did not like them pre-COVID-19 for a myriad of reasons: issues concerning a lack of clarity when notes get stacked; issues concerning calculation of options upon conversion; difficulty calculating the cap table when using; issues concerning the cap acting as too big a liquidity preference; issues around pre- and post-money calculations on conversion; and issues concerning the cap affecting later rounds. It amazes me how many issues surround a now fairly prevalent financing instrument, but I guess it is what it is.
I do not like them now because both convertible debt and notes are based on the assumption that upon the achievement of certain milestones (either explicitly stated or part of the deal), a larger investor — typically an institutional investor — will come in and set a price for the round and have the notes converted. Two assumptions are inherent here. First: the company will reach a level that will merit the investment. The investor’s job is to price the risk of having that happen. The second assumption is that a larger institutional VC will come in and value the company. This latter assumption is in question in this new era. Because we do not yet fully understand the effects COVID-19 will have on investing, the second assumption is not fully understood. Thus, a layer of complexity and risk is added to the equation. Obviously, additional risk is never helpful. Worse for the founders: this risk is outside their control; they can do everything right, and if the financing market does not work, their notes will not work.
While I expect venture capital to survive, I do expect changes. It’s interesting to speculate but impossible to accurately forecast what changes are to come for the VC world. I expect a more intense focus on basic economics, but that is just speculation. In the next 3–12 months, the looking glass may become more clear. However, in the back of every investor’s mind is the thought I wonder if they will ever get to a “qualified financings” because I have no clue anymore how qualified financing will get done.
So what to do? In my family, we have a rule that if you nix the restaurant that’s offered as a choice for dinner, you have to suggest an alternative. In that spirit, let me suggest the following:
- Price the round;
- Use a low-interest note coupled with common to serve as a preference and achieve a lower valuation (and less early-stage dilution);
- Use a royalty agreement or shared earnings agreement (see the previous blog for links); or
- Some combination thereof.
My main point, though: don’t base your company’s or your portfolio’s financing on an external force over which you have no control.
Originally published at https://firstavenueventures.com on May 1, 2020.
