Thread by @dunkhippo33

An exciting Friday tweet thread on SAFEs, convertible notes, and equity (joy!) - the key differences and things that many ppl often get wrong.

Read on >>

1) If you're raising a round of $, what should you use? A SAFE? A note? Priced round (equity)?

Also some ppl feel really strongly about certain vehicles.

What to do? And why? It can all be so confusing.

2) First, a quick primer. Read this if you're not sure what these are:

elizabethyin.com/2017/01/04/a-p…

This is a simple explanation on what these even are. I won't rehash the definitions here.

3) Now that you've read the primer (have you?) one clarification to pt out is that a SAFE (as well as the KISS) is a convertible security (mentioned in the post). That's what that is.

SAFEs != convertible notes. Ppl often think they are the same when they are quite DIFFERENT.

4) A key difference between convertible notes and SAFEs is that the former is technically DEBT. And the latter is a placeholder for EQUITY. For those in finance, you know that DEBT and EQUITY are not the same and are treated very differently.

5) For ex, if a conv note is written such that it does NOT auto convert into stock, it could be paid back (+ interest) when a co is acquired. A SAFE, tho, will convert into equity.

6) So in this example, 2 ppl may invest at the same valuation - one on a SAFE and the other on a note. But the SAFE holder may get multiples & the note holder may just get their money back...

7) These days, convertible notes can be written such that they auto convert into equity (looking more like SAFEs). So it's impt if you are signing a note to check w/ a lawyer as to the details of how it works, since notes are not standard and are all over the place.

8) SAFEs and the KISS are supposed to be standard templatized docs, so they should be the same everywhere. But I've seen many ppl try to change them to no longer be templatized.

I always ask for the redline changes to a SAFE and that's the easiest way to analyze those.

9) SAFEs and notes both often have discount rates as well as valuation caps.

What are those and what do they mean? People tend to conflate them or combine them.

10) In a standard SAFE, investors will get the BETTER (not both) of the valuation OR the discount from the next priced round.

Quick example: let's say that we are signing a SAFE that has a $20m post-money valuation cap and a 50% discount.

11) Let's say that the company raises a new round as an equity round at $50m post-money valuation.

We will either convert our investment at a $20m post-money val OR 50%*$50m post-money val equity round = $25m post money val. The former is better - we convert on the cap.

12) Now let's say the new round is actually $30m post-money valuation.

Now we will either convert our investment at the $20m post-money val OR 50%*$30m post-money val equity round = $15m post money valuation.

The latter is better - we convert on the discount rate.

13) Discount and caps are OR situations not "and". You don't get both applied.

Which leads me to valuations. Most ppl don't really know what valuations are.

Many ppl say $5m valuation cap on a SAFE. Is that pre-money or post-money?

14) There is a HUGE difference. If it's post-money valuation cap, then that means the investor could be converting at the AMOUNT INVESTED / $5m.

But if it's pre-money valuation, the conversion will be dependent on how much TOTAL money the company is taking in.

15) The variation between pre-money and post-money can be quite dramatic -- and in the pre-money scenario, and in my experience, sometimes we only have 1/2 the equity we thought we would, because the team ends up raising a lot more than they initially anticipated.

16) That's not necessarily a bad thing (the co also has more capital too), but most ppl don't realize the difference. So it's just impt to be aware.

17) For this reason, that's why a lot of investors prefer equity to convertible notes and SAFEs, because you know exactly how much equity you are buying.

18) One could argue, well with post-money SAFEs, you generally know how much equity you're buying -- you're definitely converting at a price that is the post-money valuation cap. OR possibly better if the discount kicker is better.

And I've found that to be mostly true.

19) BUT, a caveat is there are also downstream funds out there who may introduce legal language to prevent this conversion from happening the way you think it will and have the conversion be something else. 😮

This doesn't happen in most deals but it has happened.

20) Specifically, say a fund signs with a founder. If the founder doesn't understand it / doesn't have other choices, the docs can have legal language saying "we're changing conversion terms for past investors" All are forced to accept these changes or the round doesn't happen...

21) So while we do a lot of investing on SAFEs, there is always that risk looming.

The flip side is that if you're writing small checks, your legal bills will be through the roof if you do priced rounds.

There are pros and cons for everything.

22) So many more things to consider but that's the gist of where I see most hang ups.

What do you see?