Y Combinator introduces safe, a new early stage funding structure. Promises all the good of convertible notes, none of the bad
Want to know where the startup ecosystem will be in six months time? Look at where Y Combinator (YC) is today. The uber-accelerator has become a leading indicator of where the startup zeitgeist is going, whether it’s charting the hottest investment sectors du jour or setting the new standard in pro-entrepreneur seed round valuation and terms.
Today, the firm is taking the deliberate step of urging the industry in a new direction with regard to the structure of these early investment rounds. If Paul Graham and YC partner and (in-house) general counsel Carolynn Levy have their way, convertible notes will cease being the de facto Seed round structure. Nevermind, they helped popularize that trend to begin with a few years ago.
The pair hope to replace these notes with an entirely new funding structure called a “safe.” The name is derived from the acronym "simple agreement for future equity." (For brevity, they have elected to write it as all lowercase, and without punctuation.) The fact that it seemingly calls one of the world’s riskiest class of investments, the exact opposite, is simply ironic, Levy says. YC VC, the firm’s in-house funding vehicle, will back the members of the upcoming Winter 2014 class using the safe structure.
Safes are meant to offer investors and entrepreneurs the best elements of using convertible notes, such as the speed and limited legal costs associated with choosing this structure, and eliminate the most frustrating elements like interest rates and maturity dates. In a blog post today, YC describes safes as “a flexible, one-document security without numerous terms to negotiate.” Like convertible notes, safes can have a valuation cap, or be uncapped, and can convert at a discount to a future funding round valuation, or not. But, most crucially, the investment does not end up as debt. Mechanically, it’s more like a warrant, or a contractual right to purchase equity at a future date under fixed terms.
In 2008, Levy, who was then representing YC as a partner at law firm Wilson Sonsini, wrote and published a set of standard Series AA equity financing documents that became widely used in the industry. She was then instrumental in YC, and thus the rest of the industry, shifting to convertible notes in 2010 when they published a new set of standard documents through Clerky, a legal services startup which itself is a YC graduate. The impetus with both moves was to find a new structure that would allow startups and early stage investors to quickly and inexpensively agree on a basic set of funding terms, while deferring many of the thorniest structural decisions like valuation, liquidation preferences, and participation rights to larger, later-stage rounds like the Series A.
Levy says, “[In the ensuing three years,] there has been a growing consensus among startup attorneys that notes aren’t the end all, be all of early stage investment structures.” Angels and VCs aren’t in the lending business, she says, they’re in the investing business. She began toying with new structures aimed at rectifying this disconnect and solicited several rounds of feedback, first from attorneys, then fellow YC partners, and then ultimately trusted members of the investment community.
Safes are the result of this process. Although Levy and YC are happy with the structure and the state of the “standard safe documents” they’re publishing today, this is very much a test and the firm is open to iterating if it gets feedback that things can be improved. The decision to introduce a new name, rather than call safes something generic and confusing like “capped warrants” or “convertible equity” was largely an attempt at clarity – and possibly good marketing. Fortunately, they didn’t call them YCs Series Seed Units.
There are still unknowns around safes. For example, Levy has been advised that the structure will receive similar tax treatment to that of convertible notes, but advises that all investors consult tax counsel for more definitive answers to this question.
Similarly, there are scenarios which the simplistic terms and structure doesn’t address. One such case is that of a company so successful that it never raises another round of funding after a safe and never has a liquidity event. Under these circumstances, there would be no conversion trigger. Levy admits as much, but says, “If it’s gonna be simple, then you can’t draft for every single corner case.” There are very, very few companies that don’t pursue some form of liquidity, she says, but should this occur, Levy predicts that the Silicon Valley social construct would lead to a good faith workout.
The big question is, how will Silicon Valley react to the change? YC has shown an incredible ability to influence convention in the past. That said, safes are something entirely new, not simply a shift between known structures or the move to a standard, but not entirely originally, set of “standard funding documents.”
YC has given the community every opportunity to adopt safes. The firm published a blog post today introducing the concept, as well as a new section dedicated to the structure on its website. It also published a “safe primer” that goes over the why, when, and how of safes, and includes a Q&A section. They also published sample docs for four variations on safes, including: “SAFE: Cap, no Discount”; “SAFE: Discount, no Cap”; “SAFE: Cap and Discount”; and “SAFE: MFN, no Cap, no Discount.”
If safes are going to take off, investors will need to be flexible and willing to learn the nuances of a new deal structure. Fortunately, YC will give them 120 to 150 chances to practice each year across its twice-yearly accelerator batches. And as has often been the case previously, once something becomes a part of the YC way, it tends to trickle down into the rest of the ecosystem.
YC ends its blog post with a simple request:
We believe the safe is a positive evolution of the convertible note and hope the startup and investing community in Silicon Valley (and beyond) embraces it as an easier way to accomplish the same goals.
In other words: Follow me, I know the way to the startup promised land.