SAFEs v. Convertible Notes, updated.

TL;DR: Still not seeing a ton of SAFE adoption, albeit a slight uptick. Convertible Notes still dominate outside of SV and pockets of LA/NYC.

Background Reading:

A recurring theme of this blog is that the advice and strategy you take for fundraising needs to be right-sized and contextualized for where you are located. Because by an order of magnitude Silicon Valley has the most startups, VCs, large exits, etc., the majority of the content available online for founders to educate themselves comes from Silicon Valley. A lot of it is very good, but a lot is also totally inappropriate for a founder in, say, Austin, Boulder, or Atlanta (or markets like them); where the dynamics between entrepreneurs and investors are fundamentally different.

Context matters. 

Y Combinator created the SAFE (Simple Agreement for Future Equity) a few years ago as an “upgrade” on convertible notes. It is a well-drafted document, but when you get down to brass tacks, a SAFE is basically a convertible note without interest or a maturity date. Purely from the perspective of founders, it is a fantastic deal. Most convertible notes are already slimmed down in terms of investor rights, and SAFEs effectively strip those rights down even further by removing the “reckoning day” of maturity.

The problem with SAFE usage for “normals” outside of Silicon Valley (and perhaps Los Angeles and NYC, which mirror SV much more so than other markets) is that it reflects the unique market leverage of the people who produced it: Y Combinator. Apart from YC itself, Silicon Valley already is an aberration among startup ecosystems. The concentration of seed funds and venture capitalists in such a small geographic area creates a level of hyper competition that is not even close to what is seen anywhere else in the world. And Y Combinator is, to some extent, the Silicon Valley of Silicon Valley. It takes competition among investors to an even higher level, where many founders can effectively dictate terms.

It’s therefore unsurprising that YC produced a security that effectively tells investors “Here are the terms. Thank you for your money. Talk soon, when we get around to it.” That’s a slight exaggeration, but it’s not entirely off base from how many investors I run into view SAFEs. And it should therefore also be unsurprising when investors outside of that environment respond with “Excuse me?”

So when founders I work with ask me if they should consider using SAFEs, my viewpoint can be summarized as follows:

  1. Only if you believe that all of your seed investors will accept them. Because if only your earliest investors (most trusting/risk-tolerant) will take them, they are not going to be happy about later investors getting real debt, and you will have to re-do everything.
  2. In 99% of cases, you’re better off just asking for a convertible note with (i) a low interest rate, and (ii) a long maturity date (24-36 months). For all intents and purposes, it is effectively the same thing, but will keep “normal” angels investing in “normal” companies more comfortable.

A conventional convertible note with a low interest rate and reasonable maturity period represents a balanced tradeoff: give us some trust and freedom to iterate quickly and get to a serious milestone (minimal restrictions), and in exchange we’ll give you a mechanism for holding us accountable if we don’t perform (maturity). A SAFE, however, reflects the expectation that investors should hand over their money and hope for the best. I rarely see angels or seed funds that use a maturity date to actually harm the company, but that doesn’t mean it’s unreasonable for them to expect somprotection if they aren’t getting the kinds of rights (board representation, voting rights, etc.) that equity investors would get.

Know thyself, and thy leverage. 

There is a subculture among certain entrepreneurs that acts a tad self-entitled to investor money; and I’m sure you can guess where that culture originated. I can say that as a lawyer who (deliberately) represents exactly zero startup investors. I always tell my clients, if I detect it, to snap out of it. You won’t win with it. If you aren’t the CalTech/MIT superstar in the room, then don’t take her advice, or follow her lead, on how to get a job. Persistence and hustle work best when combined with self-awareness and humility.

I have seen a slight uptick in SAFE usage, but it’s almost just a blip. Convertible notes still dominate, and for understandable reasons.  They’re investors, not philanthropists to your entrepreneurial dreams. See “Angel Investors v. ‘Angel’ Investors” for understanding how many Angels you encounter actually think about startup investing.

The truth is that SAFE culture, which reflects YC culture, is a broad reflection of the binary dynamics of how Silicon Valley approaches fundraising; touched upon in Not Building a Unicorn. Billion or bust. If you haven’t made things happen and my seed investment hasn’t 5x-ed into your Series A, I’m already moving on and focusing on the unicorn in my 30-company portfolio.

But if you’re not building a unicorn, that’s not how your investors think, and you need to act accordingly.

Maturity about Maturity. 

So if the idea of your convertible notes maturing scares you, well, entrepreneurship is scary. First, ensure it’s long enough to give you a legitimate, but reasonable amount of runway to make things happen. If your angels have given you 3 years to convert their notes, that’s a very fair amount of runway. I personally think less than 24 months is usually unreasonable, given the timeline most companies need to get real traction and attract more capital.

Second, there are mechanisms you can build into a convertible note to further help with hitting maturity. The most common and important is ensuring a majority of the principal can extend maturity for everyone; so if enough of your early investors still support you, you get more time. Extensions are very common.

Automatic extension, or conversion into common stock, upon achieving certain milestones – for example, upon raising an additional convertible note round, or hitting certain metrics – are another good option. Lawyers specialized in early-stage financing can help here.

The people who are the best at sales are also the best at getting into the heads of their buyers, and understanding their concerns. The same is true for founders “selling” to investors. It is not unreasonable for investors in high risk startups to expect some downside protection in the highest risk segment of a startup’s history, and that’s why so many angels and seed funds reject SAFEs. Give them what they want, while getting what you need. And don’t spend too much time listening to people who are experts in a world that you don’t live in.

Tiered Valuation Caps

TL;DR: Using a “tiered” valuation cap structure in a convertible note or SAFE can provide flexibility that bridges the gap between (i) what founders expect their company to be worth in the near future, and (ii) what investors are comfortable accepting now.

Background Reading:

This post assumes that, for a company’s early seed round, they’ve decided to use convertible notes or SAFEs; because the majority of startups do. SAFEs and Notes are optimized for speed and simplicity, with a cost of future uncertainty and dilution. They have their downsides, which are discussed in some of the above links.

Convertible notes/SAFEs are usually executed around times of maximal uncertainty for a company; the very early stages. For that reason, pegging an appropriate valuation can be very difficult for investors. The valuation cap has evolved into a proxy for valuation, even though by definition it is in fact a cap on valuation, and if things go south, the actual valuation at which the security converts goes downward with it.

Traditional valuation caps: downside protection for investors. No upside for founders.

When you think about it, though, the valuation cap structure is a bit one-sided. If things go badly, investors get a lower price. But what if things go very well very quickly? Under the standard approach, even if the outlook for the company dramatically changes (positively) within 1 month post-closing (which at seed stage can happen), the valuation cap is what it is.  Normally this is accepted as given, much like how when you close an equity round, the price you got is the price you got.

However, there are circumstances in which founders know there are potential serious milestones on the short-term horizon that would dramatically influence valuation, but they need to close their seed money now. Obviously, smart investors reward results, not promises; so they’re not going to budge on valuation just because the founders are confident they’ll hit a milestone in a month. Tiered valuation caps are a useful mechanism for bridging this uncertainty gap in seed rounds.

Tiered valuations can bridge the uncertainty gap, and give companies some valuation upside. 

A tiered valuation cap would look something like this (language simplified because this isn’t an actual contract):

  • If the Company achieves [X milestone], the valuation cap will be [A];
  • If the Company does not achieve [X milestone], the valuation cap will instead be [B].

Convertible notes and SAFEs are optimally designed for providing this kind of valuation flexibility. It is much more complicated to implement something like this in an equity round, which is why you almost never see it. Also, there are a number of other nuances around valuation caps that are too “in the weeds” to get into in this post, but that, depending on the circumstances, may make sense for a company. One example would be, if a certain important milestone is hit, turning the valuation cap into a hard valuation.

Standardization v. Flexibility

Something related to the above that is worth briefly discussing is why, despite there being many logical circumstances in which deviation from “standardized” startup investment structures makes total sense and would be acceptable to both sides of the table, founders are often encouraged to “move fast” and stick to the usual docs.

There is a mindset in parts of the startup world – and very much coming out of Silicon Valley – that promotes the idea that startup legal documentation should all be standardized and closed as fast as possible, with minimal fuss. The PR story behind that trend – the way it gets sold – is that it’s about saving companies money. Don’t bother actually talking to counsel on these “standard” things; you’ve got to stay lean and focus on “more important” stuff.  Sounds legit.

Of course, every heavily promoted story has incentives behind it. Who benefits from saying “nevermind with the lawyers; just close quickly?” Software companies selling you the automated tool that relies on inflexible standardization, for one part. Savvy investors (repeat players) who have a 10x better understanding (than you do) of what the documents actually say, for another. As I wrote in “How to avoid ‘Captive’ Company Counsel“, it is very amusing when, during high-stakes negotiations where small variances in terms can have multi-million dollar long-term implications, certain investors take such a keen interest in “watching the legal bill.”

Everyone’s favorite sucker is the guy who shoots himself in the foot, and then sings a song about it.

Always always remember: if you’re doing this for the first time, and someone else has done it dozens, the “let’s get this done quickly” mindset is definitely saving someone money; but it’s usually not you. If a few discussions with counsel could result in a 25% higher seed valuation, you tell me if that is “wasted” legal fees. 

There are times when the standard terms make sense, but there are a lot of times when they don’t. Companies not fully on the “move fast and break things” train should slow down and take advantage of some customization when it could have a serious impact on dilution. Good investors who don’t view you as just another number in their “spray and pray” portfolio won’t criticize you for doing so.

ps. for the best companies, the “standard” valuation in an accelerator’s convertible note/SAFE is almost always negotiable.

Why Notes and SAFEs are Extra Dilutive

Background Reading:

Outside of Silicon Valley, Convertible Notes are the dominant form of seed round security. In SV, SAFEs are much more popular. The difference between the two effectively amounts to interest and a maturity date. For larger seed rounds, however, seed equity is another possibility.

The point of this post is not to debate the pluses and minuses of any of the above structures. The optimal one is, as mentioned in the above-linked posts, highly contextual. However, founders should understand that while SAFEs and Notes are faster and simpler to close on (usually), they come with a cost in the form of extra dilution relative to doing a seed equity round at an equivalent valuation. The math is as follows:

Dilution when raising seed as equity

Pre-Seed Capitalization:

You want to raise a seed round with the following terms:

  • Round size: $1.5 million
  • Valuation (cap or pre-money if equity): $6 million

You end up doing a seed equity round, with a 10% post-money pool, but with the pool top-up added to the pre-money (as it usually is). Post-close capitalization looks like:

Key to understanding what’s going on here is how the Seed Equity price gets calculated. $6 million (valuation) / (5MM Common + 714,219 pool) = $1.05.  So the seed investors paid $1.05 per share for their shares.

A year or two pass, and it’s time to do a Series A. The Series A economic terms are:

  • Round Size: $2.5 million
  • Pre-money: $10 million
  • Post-Close Available Pool: 15%

After you do the deal math (explaining that is not the point of this post), the post-close cap table looks like this:

So the above is what dilution looks like after both (i) a seed equity deal of $1.5MM at a $6MM pre with a 10% post-close available pool and then (ii) a $2.5MM Series A at a $10MM pre with a 15% post-close available pool.

Dilution when raising seed as convertible notes or SAFEs

Now let’s replay the above steps, except instead of doing an equity round for the seed, let’s do a convertible note or SAFE round. We can ignore interest, which economically makes the SAFE and Note scenario exactly the same.

Pre-Seed Capitalization:

OK, now we do a $1.5 million convertible note or SAFE with a valuation cap of $6 million. Same numbers as the above seed round, except it’s structured as a convertible security instead of an equity round.

Because these are notes or SAFEs, there’s no dilution registered yet on the cap table. The dilution math is deferred until the Series A.

So after closing the $1.5MM, we’re now at the Series A round. Because we have notes/SAFEs, we’re required to do two calculations in this round: first we calculate the conversion price of the SAFE/Note seed round, and then we calculate the price of the Series A.

Repeating the terms of the Series A:

  • Round Size: $2.5 million
  • Pre-money: $10 million (VCs insist Note shares go in pre-money to keep their post-close % at 20%)
  • Post-Close Available Pool: 15%

After we run through the deal math, this is what the cap table looks like:

The conversion price for the Note/SAFE is calculated by $6MM (valuation cap) / (5MM Common Stock + 1,530,476 Pool) = $0.92.

Now let’s compare the Post-close Series A cap table between the Seed Equity v. the Seed Note/SAFE scenarios.

Seed Equity –> Series A:

Seed Note/SAFE –> Series A:

What’s different? The Series A got the exact same ownership, because that’s how VC’s approach deal math. They will adjust the numbers to ensure they get their %. However, the Common Stock has 1.56% less ownership, all of which went to the Seed round. And the reason for that is straightforward, the Seed got a lower price, because the larger pool (post-A instead of just post-Seed) was built into their conversion math. 

In this scenario, 1.56% is about $195K in Series A post-money terms. So the decision to do seed SAFEs/Notes instead of seed equity cost the common stock nearly $200K in Series A dollars. And that’s ignoring interest, which would put that past $200K if we’re talking convertible notes with interest. I also simplified the example by ignoring actual usage of the pool in-between rounds. A real-world example would’ve had a larger pool top-up at Series A, and therefore a larger dilution gap between seed equity and notes/SAFEs.

Conceptually the way to view this is that convertible notes/SAFEs, as currently structured, have a kind of strong anti-dilution protection built into them. And that’s apart from the more obvious anti-dilution aspect relating to valuation: that a valuation cap is just a cap, and the notes will convert at a lower price if your Series A is below the cap.

If I do a seed equity round, everything that happens to the capitalization afterward dilutes everyone, including the seed equity. There is a conventional form of (soft) anti-dilution protection (typically broad-based weighted average) in seed equity, but it is rarely triggered; only in down-round scenarios. When the Series A bargain for a larger pool and put that pool in the pre-money, the seed equity doesn’t benefit from it because their math already happened.

But in the note/SAFE scenario, the seed math is deferred to the Series A round. Anything that happens to the capitalization before that date gets built into the seed note/SAFE conversion math, so they’re protected from it. This is why the seed notes/SAFEs end up paying a lower price (92 cents) instead of the higher seed equity price ($1.05). The denominator in calculating their math is larger because of the larger pool. Lots of founders think that SAFEs/Notes only have harsh anti-dilution economics if there’s a “down round.” But that’s not entirely true. The scenario I described above was not a down-round scenario. SAFEs/Notes protect investors from dilution, much more so than seed equity, in every scenario.

If companies and investors, and in the case of SAFEs, Y Combinator, wanted to really make SAFEs and Notes more equivalent in economics to seed equity, they would allow for the capitalization, for purposes of calculating the conversion price, to be set in the security. In other words, at the time of issuing the SAFEs/Notes, we would say the capitalization is X, and that is the capitalization we will use for purposes of determining the conversion price, regardless of what the Series A negotiate for their option pool adjustment. That would not be hard to do at all.  The valuation would still float and be determined at Series A, as is part of the core “deal” of a convertible security, but that full anti-dilution aspect of SAFEs/Notes would be removed.

I have never seen this solution actually implemented in the market. Why not? I’m not sure. A lot of people aren’t even aware of this economic disconnect between SAFEs/Notes and Seed Equity, so it could just be lack of awareness. Hopefully this post helps with that.  But it’s also possible that it’s just part of the “deal” that investors expect for taking convertible securities. If you ask them to move fast and take minimal protections/rights in exchange for their money, part of the price is extra dilution.

Whether or not founders think that price is fair will obviously depend on the circumstances of their company.  The goal of this post was not to give an opinion on SAFEs v. Notes v. Seed Equity, because my opinion is that they are all good for different circumstances. They all have their positives and negatives. All I wanted founders to understand is that there is an economic price to using SAFEs/Notes. Make sure it’s really worth paying.

Did you get a “good” valuation?

TL;DR: What a “good” valuation is depends highly on context: geography, industry, timing, size, team experience, value-add of money, control terms, and a dozen other variables. Be careful using very fuzzy guidelines/statistics, or anecdotes, for assessing whether you got a good deal. The best valuation for your company is ultimately the one that closes.

VC lawyers get asked all the time by their clients to judge whether their financing terms are good, fair, etc; especially valuation. And that’s for good reason. There are very few players in ecosystems who see enough volume and breadth of deals to provide a truly informed assessment of a financing’s terms. Executives have usually only seen their own companies. Accelerators see only their cohort’s. Most advisors/mentors have even more limited visibility.

But VC lawyers/firms with well-established practices see deals that cross geographic, industry, stage, etc. boundaries.  In addition to a firm’s internal deal flow, there are third-party resources that can be subscribed to with data on VC valuations across the country and the world. Those resources tend to be expensive (5-figure annual subscriptions), and only firms with deep VC practices will pay for them. Given how much you’ll be relying on your lawyers for advice on your financing terms (for the above-mentioned reasons), ensuring that they are objective (and not biased in favor of your investors) is crucial. 

The above all being said, founders should understand that determining valuation at the early stages of a company (seed, Series A, B) is far far more an art than a science. It is for the investor making the investment, and it is for the people judging whether the terms are “good.” That’s why relying on broad metrics like “median Series A valuation is X” is problematic; there are simply too many variables for each company that could justify deviating from the median, in either direction (lower or higher).

What some people call a seed round, others might call a Series A. Some companies raise a Series A very early on in their company’s history because the nature of their product requires serious capital expense to even get to early milestones. Other companies bootstrap for a decade and only use a Series A as true growth capital (the way others would use a Series C or D). I saw a $150MM ‘Series A’ once. I’ve also seen $500K ‘Series A’s. And everything in between as well. So whenever someone asks me “what’s a good Seed or Series A valuation?” the answer has to start out with: “it depends.” 

Below is a break-down of the mental analysis that I might use in assessing a company’s valuation. Remember, it is an art, not a science. There are widely varying opinions here, and this is just one of them. Consider it a set of suggested guidelines, not rules.

1. What was the last valuation a professional investor was willing to pay, and what progress has been made since then?

The easiest answer to “what is X worth?” is “whatever price someone was willing to pay.” While not entirely helpful in the VC context, it certainly is relevant. If you’re doing a Series A and you have institutionals who invested in a convertible note at a $5MM cap a year ago, the obvious question then is “how much progress has been made since then?” This, btw, is why it’s dangerous for companies to set their own valuations without a true market check from professional investors. Your earlier valuations will influence your later ones.

2. What city are you in?

Location. Location. Location. One of the strongest determinants of valuations is the density of startup capital in the city your company operates in; because density means competition. Silicon Valley valuations are not 2-3x those of the rest of the country because the VCs there are just nice guys who are willing to pay more. It’s a function of market competition. SV has the highest valuations. NYC follows. And then there’s the rest of the country, with variations by city. Austin valuations are generally higher than Atlanta’s, which are generally higher than Houston’s or Miami’s. General deal terms are also more company-friendly where there is more investment density.

While the entire concept of “founder friendly” investors does have an important moral/human dynamic to it, people who play in the space enough know that at some foundational level it is a form of self-interested brand differentiation. The ‘friendliest’ investors are the ones in the most competitive, transparent (reputationally) markets. Why take our money over theirs? Because we’re ‘founder friendly’… which can mean a whole lot of things; some of which are relevant, and others which are nonsense.

Yes, online networks are breaking down geographic barriers and you are seeing more capital flow between cities/states, but the data is still crystal clear that if a Silicon Valley VC is investing in an Atlanta or Austin company, they are going to want to pay something closer to Atlanta or Austin (not SV) prices. Much like all the Ex-Californians buying up Austin homes, they likely will pay slightly above the local market (and in both cases, it pisses off local buyers), but not much. 

3. How much is being raised?

Valuations can (and often do) vary widely between markets, while the actual dilution that founders absorb doesn’t vary as much. How is that? Because founders in markets with higher valuations raise larger amounts of money, and founders in markets with lower valuations raise smaller amounts of money; in each case getting the VCs/investors to their desired %. A $1MM raise at a $4MM valuation produces the same dilution as a $5MM raise at a $20MM valuation.

You should never close any round without modeling (lawyers often help here) the actual dilution you are going to absorb from the round, including any changes required to your option pool. Many investors focus first on their desired % and then back into the right valuation and round size. Smart founders should focus on %s as well. It’s not intuitive; especially if you have multiple rounds involved.

4. Who are the investors?

Value-add, known-brand institutional VCs and professional angels that will be deeply engaged in building your company after the check hits are (obviously) worth a lot more than investors who just bring money. And they will often price themselves accordingly (lower valuations). Some money is greener.

Diligencing the valuations your specific investors were willing to pay for their past investments is a smart move. Again, it still requires discussions about the differences between companies, but it can help address any statements like “we never pay more than $X MM for Series A.”

5. What are the other terms?

A $4MM valuation with a 1x non-participating liquidation preference looks very very different in an exit from a $6MM valuation with a 2x participating liquidation preference. So does a $3.5MM valuation with investors getting 1 out of 3 Board seats v. a $5MM valuation with them getting 2/3. The non-valuation terms matter. A lot. Juicing up valuations by accepting terrible ‘other’ terms gets a lot of companies in trouble. 

6. Other Business-Focused Variables

  • What are valuations within this specific industry looking like over the past 12 months?
  • What are the obvious acquirers paying for companies they buy?
  • Where is the company in terms of revenue? Revenue-multiples generally don’t have a place in early-stage, but a $25K MRR v. $300K MRR absolutely influences valuation.
  • Any serial entrepreneurs on the team? Good schools? Other de-risking signals?
  • What’s growth look like?
  • Size of market?
  • etc. etc. etc.

Obviously, multiple term sheets are a great way to have a very clear idea of where your valuation should be, but in most non-SV markets that is a privilege bestowed on a small fraction of companies.

Take-homes:

A. If your friend’s startup got X valuation for their Series A round, that can be totally irrelevant to what valuation you should get,

B. Other terms of the financing matter a lot too, as well as who is delivering them, and

C. If you have in your hand a deal that isn’t exactly at the valuation you wanted, remember that there are thousands of founders out there who got a valuation of $0.

Over-optimizing for valuation can mean under-optimizing on a host of things that matter far more for building your business. Get the best deal that you can actually get, given your business, location, and investors, and then move forward. And ignore the broad market data, particularly the Silicon Valley data, that isn’t relevant to your own company.

The Best Seed Round Structure Is the One that Closes

NutshellPeople with strong opinions can argue endlessly about whether founders should be structuring their seed rounds as convertible notes/SAFEs or equity. The problem is that the optimal structure for any type of financing is highly contextual, so anyone offering absolutes on the subject should just “Put that Coffee Down” in the Glengarry sense, before they hurt someone.  The X round that closes is better than the Y round that doesn’t.

Complete standardization of startup financing structures has been a pipe dream for over a decade. Every once in a while someone will produce a new type of security, or flavor of an existing security, and proclaim its superiority. The problem, of course, is very much like the problem faced by any product whose founders hopelessly believe that it will achieve market dominance on technical superiority alone: distribution channels, inertia, and human idiosyncrasies.  In the end, a financing is the act of convincing someone, somewhere, to give you money in exchange for certain rights that they value enough to close the deal.  Values are pesky, subjective things that don’t do well with uniformity.

Outside of Silicon Valley and a very small number of other markets, the people writing the early checks are usually not all rich techies in jeans and t-shirts debating the latest startup/angel investing trends on twitter. Even in Austin they aren’t. They’re successful individuals with their own backgrounds, culture, and values, and very often won’t give a rat’s ass about a blog post saying they should suddenly stop using X security and use Y instead.

So let’s start with the core principle of this post: The Best Seed Round Structure Is the One that Closes. That means priority #1, 2, and 3 for a group of founders is to get the money in the bank. Only from there can you work backward into what seed structure is optimal.

SAFEs are better than Notes? Many non-SV investors don’t care.

This was the same reasoning in a prior post of mine: Should Texas Founders Use SAFEs? To summarize my answer: unless a TX founder is absolutely certain that every investor they want in the round will be comfortable with a SAFE, it’s usually not worth the hassle, and they can get 99% of the same deal by just tweaking a convertible note. Yes, a SAFE is technically better for the Company than a convertible note, and YC has done a great thing by pushing their use. But the differences are (frankly) immaterial if they pose any risk of slowing down or disrupting your seed raise. Here’s what a conversation will often sound like between a founder (not in SV or NYC) and their angel investor:

Angel: Why do we need to use this SAFE thing instead of a familiar convertible note? I read the main parts and seems pretty similar.

Founder: Well, it doesn’t have a maturity date, in case we don’t hit our QF threshold.

Angel: So you’re that worried about failing to hit your milestones and hitting maturity?

:: long pause::

Put. That Coffee. Down.

Debt v. Equity? Do you really have a choice?

There are so many blog posts outlining the pluses and minuses of convertible notes/SAFEs v. equity that I’m going to stay extremely high-level here. The core fact to drive home on the subject is that the two structures are optimized for very different things, and that’s why people debate them so much. Your opinion depends on which thing you value, and that will depend on context.

Convertible Notes/SAFEs are built for maximal speed and flexibility/control up-front. Cost: Dilution, Uncertainty. You defer virtually all real negotiations to the future, save for 2-3 numbers, and note holders often have minimal rights. You can also change your valuation quickly over time, at minimal upfront cost, as milestones are hit. The price for that speed is you’ll usually end up with more dilution (because notes have a kind of anti-dilution built into them) and possibly more liquidation preference. See: The Problem in Everyone’s Capped Convertible Notes You’ll also pay a harsher penalty if your valuation goes south before a set of Notes/SAFEs convert than if you’d done equity from the start.

Equity rounds are built for providing certainty on rights and dilution. Cost: Legal Fees, Control, Complexity. An equity round is more inflexible, and slower than debt/SAFEs, but the key benefit is that at closing, you know exactly what rights/ownership everyone got for the money.  Those rights are generally much more extensive than what note/SAFEholders get. If the business goes south, or the fundraising environment worsens significantly, you’ll pay a lower penalty than if you’d done a note/SAFE. But for that certainty, you’ll pay 10x+ the legal fees of a note round (if you do a full VC-style equity round), and have 10x the documentation. That’s why you rarely see a full equity round smaller than $1MM.

Raising only $250K at X valuation and planning to raise another $500-750K at a higher valuation soon, before your A round, because you’re super optimistic about the next 6-12 months? Note/SAFE probably. Raising a full $1.5MM round all at once that will last you 12-18 months, with a true lead? Probably equity.

Seed Equity is a nice middle ground, but if your investors won’t do it, it’s just theoretical. Series Seed, Series AA, Plain Preferred, etc. Seed Equity docs are highly simplified versions of the full VC-style equity docs used in a Series A. They are still about 2-3x the cost of a convertible note round to close in terms of legal fees, but dramatically faster and cheaper than a full equity set. They are a valuable middle ground for greater certainty, but minimal complexity and cost.

But after pondering the nice theoretical benefits of seed equity, we’re back to reality: will your seed investors actually close a seed equity deal? I can’t tell you the answer without asking them, but I can tell you that I know a lot of seed investors in TX and other parts of the country, including professional institutionals, who would never sign seed equity docs.

There is an obvious tradeoff in the convertible note/SAFE structure that has become culturally acceptable for both sides of the deal. Founders get more control and speed up-front, and investors get more downside protection and reassurance that in the future they will get strong investor rights negotiated by a strong lead.

With seed equity, investors are (like with Notes) being asked to put in their money quickly with minimal fuss, but without the downside protection of a note/SAFE, and with significantly simpler investor rights. Many seed investors see that as an imbalanced tradeoff. Whether or not they are right isn’t a question that lends itself to a single answer. It’s subjective, which means the Golden Rule: whoever has the gold makes the rules.  Can they beef up those protections in the next large round? Sure, but many don’t see it that way, and good luck ‘enlightening’ them when every delay brings more reasons for why the round may never close.

I think seed equity is great, and am happy to see founders use it as an alternative to Notes or SAFEs for their seed raise. But that doesn’t change the fact that for every 10-15 seed deals I see, maybe 1 is true, simplified seed equity. And those usually look far more like Friends and Family rounds – where the investors are so friendly that they don’t care about the structure – instead of a true seed with professional seed money.

When it comes down to getting non-SV seed money in the bank, most founders only really have 2 choices for their seed structure: convertible notes or a full equity round. If you’re lucky enough to get a SAFE or seed equity, fantastic. Go for it. But don’t let the advice of people outside of your market, with minimal knowledge of your own investor base, cloud your judgment with theories. When a team debates what type of product to build, the starting point isn’t which one is technically superior, but which one their specific users will actually pay for. Seed round structuring (like coffee) is for closers.