SAFE Notes are a west coast deal type that does not lend itself well to the Heartland. Entrepreneurs love them, but we feel they don’t adequately pay for the risk investors are taking without a substantial discount. Financial Poise makes several good points, with which we agree, as does Kevin Learned with Investor Beware Common Equity SAFE Notes.

Experienced angel investors are skeptical about whether issuers are willing to offer sufficiently generous discounts in particular…. Considering the much greater level of risk that seed-stage investors take on compared with later-stage investors, 15 percent might not seem like much of a reward to sophisticated angel investors. Try 50 percent, which would represent a 2x valuation jump from the CF round to the liquidity event, quite reasonable when the time between events is indefinite.

But crowdfunding investors under Title III will be more socially motivated than traditional angels whose primary motivation is ROI. Average Title III investors (a) will gravitate to simplicity, (b) might not be able to judge whether the valuation cap makes any sense whatsoever, and (c) will often settle for a half-decent discount on share price just to get in on the ground floor of an exciting startup…

Paul Graham, one of America’s premier angel investors and a founder of Y Combinator, wrote this in 2009:

Don’t spend much time worrying about the details of deal terms, especially when you start angel investing. That’s not how you win at this game. When you hear people talking about a successful angel investor, they’re not saying, “He got a 4x liquidation preference.” They’re saying, “He invested in Google.” When angels make a lot of money from a deal, it’s not because they invested at a valuation of $1.5 million instead of $3 million. It’s because the company was really successful.

Again, many experienced angels may disagree with that approach, because they must maximize return on investment every time in order to be successful – that’s their full-time job. Graham’s advice is better suited to part-time angels whose primary motivation is to help entrepreneurs they admire, support community development, own a piece of their favorite hangout or brand, or simply have as much fun as those “Shark Tank” investors seem to have.

If you aren’t familiar with Paul Graham, you may wish to look up his writings on the internet. Graham has definite opinions about a lot of things to do with startups. He’s written that to re-create Silicon Valley elsewhere in the country would require only two things: A concentration of smart “nerds” who live and work in association with a world-class research university (not just any college or university) and a concentration of “rich people” who will gravitate to where nerds who prefer quiet coffee shops to bustling entertainment districts reside.

Most of us don’t live in the sort of place that Paul Graham describes. Graham writes off any place that has a reputation for glitz (South Florida, Las Vegas…), any place with inclement weather (Pittsburg, Upstate NY), any place where there isn’t a concentration of wealth (most of the South and Midwest), and any place predominated by government workers or people funded by the government (any capital city). Which is to say that Graham doesn’t hold out hope for new “Silicon Valleys” popping up like mushrooms across the nation.

We point this out because Paul Graham argues from a very “Silicon Valley” perspective. Fully one-third of all the venture capital deals in the US are made in and around Silicon Valley. With so much money in play, investors may indeed be “playing the numbers” by making quick, easy-to-close investments in A LOT of startups, hoping that a small percentage of a large number of deals pay off. In our market, we find that to be a challenging strategy.

Moreover, the “fail fast” ethos of Silicon Valley presumes that small amounts of capital are at risk early on. Other than software companies (and maybe food startups), I don’t know of many new ventures that can gain significant traction after receiving only a small amount of funding–say $25K-50K in the first go. SAFE notes (and convertible notes) are best suited to provide bridge funding for companies needing small investment in order to reach a significant milestone or step-up in valuation.

SAFE notes and convertible notes are BEING MISUSED in our industry to provide large amounts of early stage funding on terms favorable to entrepreneurs with little regard for investors’ risk. We have come out repeatedly against using any bridge funding vehicle to raise more than a few hundreds of thousands of dollars for a startup or small business. Allowing entrepreneurs to take on as much as a million dollars in convertible debt impairs the company’s balance sheet and increases the likelihood that later stage investors (if there are any) will force the company to dilute the early investors upon conversion of the notes.

So yes; ACG has seen deals in the past couple of years that involved SAFE notes. We’ve never invested in one. And while we could be convinced to invest in a SAFE deal for a small amount as a form of bridge financing, we strongly reject the idea of using SAFEs or convertible debt to provide major funding–even when angels’ “primary motivation is to help entrepreneurs they admire, support community development,” or the other justifications Graham provides.

This is published under the Appalachian Regional Commission POWER Grant, PW-1835-M.

Copyright Appalachian Investors Alliance, Inc. 2018
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