A Physical Social Network℠

Thanks to Ross Carmel and Benjamin Sklar of Sichenzia Ross Ference Carmel LLP for their guidance and feedback on this article.

Advances in AI are enabling startups to grow a lot faster with a lot less capital, and it’s causing a major shift in how founders approach funding. In recent months, more founders have decided to seedstrap: raise just a seed round of funding and then using the cash flow for the foreseeable future, rather than raising more money or exiting through an initial public offering or a buyout.

This paradigm shift has highlighted a previously insignificant problem with the industry-standard investment vehicle for U.S. startups. The SAFE (Simple Agreement for Future Equity), recently used by 88% of startups in the U.S., was built for an era when companies typically went through the gauntlet of multiple funding rounds with relatively predictable exit timelines. As it is written today, the standard SAFE template doesn’t address the changing needs of the startup ecosystem.

I’m just a startup founder with a tech community, not an attorney or investor, but I listen to a lot of players in the startup ecosystem, including investors, attorneys, and founders, and they’ve started to notice this gap in the SAFE. They’re concerned about AI disruption leading to stalled venture capital returns. I believe that with a small change to the SAFE, we can begin to address this issue.

Liquidity Crunch and the SAFE

Y Combinator revolutionized startup investing in 2013 by replacing the convertible note with the SAFE. Compared to convertible notes, SAFEs are friendlier to founders because they are not loans: they have no repayment date and do not accrue interest. 

But for SAFE aficionados, there has always been a structural problem with the document that has up to now seemed only abstract. Most SAFEs, which function as a promise to investors that they will receive future shares, only convert on one of two conditions: if a company exits (either through private acquisition or IPO) or if it raises additional capital on a priced round.

Notably not taken into account is the other remaining scenario for a successful company: it operates sustainably but doesn’t raise more capital or exit. 

Two trends are making this scenario a real problem: One is the very recent rise of seedstrapping. The other is the more longstanding IPO drought, which is stopping investors from recouping their capital as quickly as they previously expected. Unable to monetize their investments through IPOs — especially in a time of economic instability — investors (particularly smaller funds) are facing a liquidity crunch, as evidenced by the increase in the number of zombie funds. No longer able to rely on ‘unicorn or bust’ to keep going, equity investors are turning to the vibrant secondary markets.

But the addition of seedstrapping to the equation prevents investors from taking advantage of the secondary markets in this way because, to my knowledge, there is not a vigorous secondary market for SAFEs. In fact, most SAFEs can’t be sold on secondary markets; the standard YC template includes a non-transferability clause that requires written consent from the company to transfer the SAFE. We need to make a minor change to the terms of the SAFE to guarantee that the investor has the option to convert it once the company has some value.

A New Solution

To keep up with this evolving landscape, I propose a small revision to the SAFE to include the option for investors to convert to shares with a different kind of triggering event than equity financing or exit: a milestone.

In this solution, the investor has the option to convert the SAFE when the company reaches a pre-determined milestone that indicates success — for example, annual recurring revenue, year-over-year growth, profit margin, or user growth. This solution varies slightly based on the type of SAFE you’re using.

• For an uncapped SAFE, when the milestone is triggered, the company undergoes a 409A valuation (if it is not being done already) to determine the price of shares, and investors have the option to convert to shares within a period of 90 days of the milestone.

• For a capped SAFE, when the milestone is triggered, shares would convert at the pre-designated valuation cap.

There are several other proposals floating around that could address the non-conversion problem with the SAFE. One that seems promising on its face was introduced to the U.S. by London-based legal services platform SeedLegals. They have productized a SAFE-like instrument with the option to add a clause that it will convert to shares at a certain date if the company doesn’t undergo equity financing, exit, or liquidation.

Originally intended to help UK angel investors take advantage of time-limited tax benefits when investing in US companies, functionally, this solution ensures that investors won’t be stuck in ‘capital purgatory.’ But the terms dictate that the conversion should occur on a pre-determined valuation (separate from the valuation cap), essentially turning the SAFE into a slightly delayed priced round from the get-go, negating the original benefit of the SAFE: making investment possible without knowing the value of the company.

Instead of having a company convert SAFEs to shares at price designated before the company has proven any value, I propose setting a milestone-based trigger that would prompt a 409A valuation, and then providing the investor a limited window in which they can call their shares to convert. This way, if a company demonstrates that it is performing well, the investors’ shares convert at a price representative of their value at that time.

If founders and investors are more comfortable with a traditional valuation cap, however, the milestone can simply precipitate the shares converting at the valuation cap.

Critics say investors might want to keep a SAFE unconverted to maintain its anti-dilution protections for longer. However, in an age where liquidity assumes greater importance, the option of a milestone-based or date-based conversion allows investors to weigh the benefits of anti-dilution protections of unconverted SAFEs against the liquidity and tax¹ benefits of converted shares, depending on their needs.

Long-Term Consequences

To a certain extent, the long-term relevance of this proposal depends on the likelihood that seedstrapping becomes the new norm. Although seedstrapping may be seen as a fad, why leave the future of startup investment to chance if it’s possible to have an infrastructure that protects the investor in any scenario?

But regardless of the future of seedstrapping, timelines to IPOs are increasing. Money is tied up for longer stretches of time. Small venture funds are closing or unable to raise additional capital. It’s time to get out of the mindset of ‘unicorn or bust’ and acknowledge reality: just like cash flow matters for businesses, liquidity matters for venture capitalists.

Not tackling this problem poses a significant long-term threat to the startup ecosystem. If investors feel their cash won’t result in a direct financial return within a reasonable timeframe — even if the companies they invest in are financially successful — they could deploy less capital in early-stage companies or none at all.

A milestone-based conversion clause to the SAFE would help ensure that investors feel secure deploying capital to startups for years to come. The startup world — including my fellow founders — needs to acknowledge that there’s a missed opportunity in the standard SAFE template to make it work better for both the investor and the company. Getting on board with our suggested solution could pave the way for investors to expect value from all the successful startups they invest in, not just pray for their unicorns to exit.

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1. Stock in non-public companies has two major tax benefits: the Qualified Small Business Stock (QSBS) exclusion and IRC §1244 for tax relief for losses. The IRS has not yet taken a stance on whether SAFEs should be taxed as stock, leaving the conditions around QSBS murky and uncertain for SAFE holders. IRC §1244 does not apply to SAFE holders at all. Thanks to Max Coglin of SeedLegals for introducing me to these tax implications. ↩︎