SAFES and Startups: A Slice of the Funding Pie That Investors Either Relish or Run From
In the world of startup financing, Simple Agreements for Future Equity (SAFEs) often spark a polarizing debate: some investors love them for their simplicity and flexibility, while others approach them with caution due to their inherent uncertainties. At Raze, we understand both sides of the story and we try to take the friction out of everything we work on with customers. Think of it like a bustling pizza shop where every customer has a different taste preference.
The Pizza Shop Analogy
Imagine your startup as a new, promising pizza shop. To grow your business, you need funds, but how do you decide who gets a piece of the pie, especially when its value isn’t clear yet? This is where SAFEs come into play, akin to offering a future slice of your pizza to investors.
Love and Skepticism: The Two Sides of SAFEs
Why Founders Use SAFE
- No Need to Decide Value Immediately: When you start your pizza shop, it’s hard to say how much each slice (or share of your business) is worth. With a SAFE, you don’t have to decide this right away.
- Flexibility: It’s easier and quicker to get investments through SAFEs compared to traditional methods, which is helpful when you’re just starting and need money fast.
Pre-Money Valuation vs. Discount in SAFEs
- Pre-Money Valuation SAFE: This is like saying, “I’ll give you a slice of my pizza shop based on what it’s worth now, before I get more investment.” If your shop is worth 10 slices now, an investor might get 1 slice for their investment. Even if your shop grows to be worth 20 slices later, they still keep their 1 slice.
- Discount SAFE: This is like offering a discount on future slices. You tell an investor, “You can buy slices later, but at a cheaper price than what others will pay.” So, if in the future, 1 slice costs 2 dollars for others, the investor can buy it for 1.6 dollars (if you offer a 20% discount).
Why Others Are Cautious: On the flip side, some investors are wary of SAFEs. They’re concerned about the future – what if the pizza shop doesn’t grow as expected, or if the slices they eventually receive are smaller than anticipated due to dilution? It’s a risk that comes with not knowing exactly how big the pizza (company) will be.
Equity Distribution: A Balancing Act
Just like how you wouldn’t want to give away too much pizza before knowing how many customers you’ll have, as a founder, you must be cautious about distributing equity. Whether it’s to co-founders, advisors, or employees, each slice given away could mean less for you, especially if your pizza shop becomes the next big hit.
A Pizza Example
Now, let’s say your pizza shop has 10 slices (shares of the business). If you promise too many slices to other people early on, you might not have many slices left for yourself.
- Co-founders: You might give 3 slices to a friend who helps you start the pizza shop.
- Advisors and Employees: You give 2 slices to people who give you good advice and 1 slice to a chef.
- Leftover for You: Now, you only have 4 slices out of the original 10, which means you own less of your pizza shop.
- Dilution Impact: Every slice given away reduces the founder’s share. If the company grows and the pizza becomes bigger (more shares are issued), the founder’s remaining slices become a smaller percentage of a larger pizza. This can result in the founder owning a much smaller part of the company than intended.
Understanding the varying preferences of traditional angel investors and early-stage venture capitalists (VCs) towards SAFEs (Simple Agreements for Future Equity) is essential in the startup world. Let’s dive into this using our familiar pizza shop analogy, and also touch on how SAFEs originated from the VC Y-Combinator model.
Traditional Angel Investors: The Classic Pizza Lovers
Imagine traditional angel investors as classic pizza lovers. They are accustomed to a certain way of investing in pizza shops (startups):
- Preference for Simplicity: These investors are used to straightforward transactions, like buying a slice of pizza for a clear price. Traditional equity investments are more transparent and familiar, just like ordering a classic pizza.
- Valuation Concerns: With SAFEs, the value of their slice is uncertain until a future event. It’s like paying for a pizza now and not knowing how big or flavorful it will be when it’s served. This uncertainty can be uncomfortable for investors who prefer to know exactly what they’re getting.
- Risk of Dilution: Angel investors might worry about dilution with SAFEs. If the pizza shop expands and adds more slices (issues more shares), their slice (equity) could become a smaller portion of the pie, even if the shop becomes more popular.
Early Stage VCs: The Modern Pizza Enthusiasts
Early-stage VCs, on the other hand, can be likened to modern pizza enthusiasts who are open to new flavors and concepts:
- Flexibility and Speed: VCs often appreciate the flexibility of SAFEs. It’s like pre-ordering a specialty pizza that’s still being perfected. They can quickly invest without waiting for the shop to establish a firm value.
- Growth Potential Over Immediate Value: Early-stage VCs are usually more focused on the potential growth of a pizza shop, rather than its current size. SAFEs allow them to invest in promising shops early on, with the expectation of significant growth.
- Used to Complexity: These investors are often more comfortable with complex investment structures. Just as a modern pizza enthusiast might appreciate a pizza with an unusual combination of toppings, VCs understand and navigate the complexities of SAFEs.
SAFEs and the Y-Combinator Influence
SAFEs were created by Y-Combinator, a well-known startup accelerator, as a new recipe in startup financing. Y-Combinator is like a renowned chef who introduced a groundbreaking new pizza to the market. They recognized the need for a simpler, more founder-friendly way for startups to raise funds without immediately setting a valuation – akin to offering a new way to order pizza without deciding on the size or toppings right away.
Y-Combinator’s introduction of SAFEs revolutionized the startup funding landscape, offering a middle ground between traditional equity investments and more complex convertible notes. This innovation has been particularly influential in the realm of early-stage startups, where speed and flexibility are often crucial ingredients for success.
In summary, traditional angel investors, like classic pizza lovers, often prefer the straightforwardness and clarity of traditional equity investments. In contrast, early-stage VCs, akin to modern pizza enthusiasts, are more open to the flexibility and growth potential that SAFEs offer. The introduction of SAFEs by Y-Combinator is like a new pizza recipe that changed the startup funding menu, offering a novel option that caters to the evolving tastes and needs of the startup world.
Raze: Crafting Your Perfect Funding Recipe
Whether you’re a founder trying to understand the best way to fund your startup, or an investor weighing the pros and cons of SAFEs, Raze is your one-stop solution. Our platform assists startups through various funding stages, be it SAFEs, equity rounds, convertible notes, revenue financing, or even token raises.