In terms of how a typical emerging tech company (startup) raises seed capital, there are 3 options that from our experience make up 95+% of rounds: Equity (Preferred Stock), Convertible Notes, and SAFEs (Simple Agreement for Future Equity).
If you want a deeper dive into their pluses and minuses, read the above-linked posts. At a high-level, equity (stock) is more complex to negotiate, draft, and close, but has the benefit of greater certainty. Larger rounds tend to be closed as equity. “Seed equity” is a subset of equity financing using slimmed down, very template-ized documentation that can be closed much more quickly (with lower legal fees) than a full VC-style equity round. When rounds below $1.5-2 million are to be closed as an equity round, we see Seed Equity being increasingly utilized as an option.
Apart from equity, there are convertible securities, with convertible notes and SAFEs being the 2 dominant forms. Convertible securities are much easier to draft (lower fees) because they defer a lot of the hard issues/negotiations to the future. But the cost is more uncertainty, and also somewhat more dilution.
A convertible note is effectively a debt instrument that intends to convert into equity in the future, when a larger financing occurs. It has a maturity date (like a loan) that sets a deadline on the company reaching that milestone financing, or else a discussion/re-negotiation with the investors needs to happen.
SAFEs are basically convertible notes without a maturity date. They also convert into equity in the future, but there is no “deadline” of a maturity date, which is much more company favorable, and investor unfavorable.
A recent survey of seed financing structures reveals that in California, where the volume and density of seed investment (and competition among investors) is magnitudes higher than the rest of the country, SAFEs are well on their way to becoming a dominant seed round instrument. SAFEs were originally created by Y Combinator.
A key takeaway from that survey, and which I’ve emphasized several times before, is that entrepreneurs in Colorado, Texas, and other ecosystems should be very careful to not extrapolate trends in Silicon Valley into their companies, because the norms of their local investor community are likely different. Among convertible security seed rounds, convertible notes are far more preferred by seed investors here than SAFEs.
I don’t represent a single tech investor, for reasons I’ve written about in How to Avoid “Captive” Company Counsel, so I can speak with total impartiality in saying that SAFEs are extremely company friendly to the point of being somewhat ridiculous in many cases.
The “deal” between an investor and company in a convertible note round is that the investor will accept fewer rights upfront (which is risky for them), but the maturity date and debt aspect of the investment provides them some protection. A SAFE basically tells an investor to accept all of those downsides (fewer rights upfront), and yet let go of that protection. Hope for the best.
It’s no surprise that SAFEs came from YC. Already within California, there is much more competition among investors to get into the top startup rounds, so terms in general are more company friendly. YC is the elite of Silicon Valley in many respects, so YC companies by default are able to dictate terms much more easily to investors than a typical startup.
Still, as the data shows, SAFE rounds outside of Silicon Valley do happen. We certainly close them. But the core point here is to not get too hung up on them. We too often see founders try starting out with a SAFE, and then have to change course mid-round (which is more costly) because a serious investor gave them a reality check. Better to focus on convertible notes, if you’re doing a convertible round. As long as the maturity date is far off enough (2-3 years), get the money and move forward.