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What SAFEs Might Actually Tell Us About the Angel Financing Market

February 8, 2016

I had the opportunity to give some thought recently to the comparative advantages and disadvantages to both startups and angel investors of structuring a company’s initial financing using convertible notes as opposed to SAFEs. Net, net, I did not come away with any profound preference for one or the other structure for either group. Because each document can relatively easily morph into the other, neither can claim many permanent structural advantages.

That said, there may be a structural tax distinction for an angel investor. I would expect that an investor’s tax holding period would begin with the purchase of a convertible note. When the note converts, the holding period for the preferred stock should “tack” (i.e., be retroactive to the issuance of the convertible note). This is probably not the case with a SAFE which, more like an option, might start the investor’s tax holding period only upon “exercise” of the SAFE (i.e., conversion of the SAFE into preferred stock).

This may not be as bad as it sounds. Even if the investor’s preferred stock holding period is delayed, the horizon for holding the types of early stage investments more typical to SAFEs likely far exceeds one year from conversion into the Company’s first round of preferred stock. Since there is no advantage to be had beyond a one year holding period [1], an angel investor may not suffer any adverse tax consequences.

There remains, however, the possibility of an early exit event. Here, many will cite Twitter’s acquisition of Vine (which occurred something like 30 seconds after the company was formed). In such an instance (and assuming an all cash sale), holders of SAFEs could actually sell the SAFE itself to obtain optimal tax treatment in the sale transaction. If the SAFE had been outstanding for at least one year at the time of the sale, long term capital gain treatment should be available. [2] Thus, the only potentially unfortunate tax scenarios would occur in connection with a non-cash sale or a sale occurring less than one year following the issuance of the SAFE (both of which might create similar problems for convertible note holders) or in a sale occurring less than one year following conversion/exercise of the SAFE. In this last instance, the difference between the SAFE and convertible note structures would likely be present for selling investors.

What I found more interesting was what the introduction of SAFEs into the early stage financing market tells us about that market itself. Under most analyses, the distinction between SAFEs and convertible notes is more one of form than one of substance, save three qualities of convertible notes that could – but seem not to – translate into the SAFE structure. They are an interest rate, a maturity date and events of default. Again, any or all of these features could be incorporated in one way or another into a SAFE. Of course, if they all were, we might need to come up with a new name for a SAFE (the leading candidate being “convertible note”).

Let’s run with that for a second. Suppose that instead of proposing a separate security, startups made the following proposal to angel investors: “we want you to purchase convertible notes, but we want the terms of our notes to have no maturity date, interest rate or events of default.” At the very least, that would be a plausible conversation. However, it would be rational to expect that in response, angel investors would seek some compensation for these concessions. Usual suspects might be a higher conversion discount or a lower conversion cap (there perhaps being no other substantive terms left at this point).

Thus, in a well-functioning market, there should be evidence of bargaining in exchange for the use of the SAFE structure in lieu of convertible notes. I have never seen this done explicitly – investors saying: “well, I can accept a SAFE, but I want a lower cap and/or a higher discount rate.” In addition, it would be difficult to confirm that such bargaining occurs implicitly, but with a large enough data set, I would expect that the “average” cap and discount negotiated in SAFE transactions to reflect this bargaining relative to the same averages in convertible note financings. Thus far, that does not appear to be the case.

At least two possible interpretations follow. First, angel investors may place no value on features such as an interest rate a maturity date or having events of default. As such, investors would not believe themselves to be in a position to bargain for any benefit from conceding these features. This interpretation is plausible. After all, few if any angel investors look to early stage investment for their attractive (where else in this market can you get an interest rate comparable with that offered for convertible notes?) fixed income features. Instead, these investments tend to fall into the “swing for the fence” category, where risk is pervasive but understood. Second, the well-understood proposition for convertible notes is that they should convert prior to maturity. Convertible notes were at one point more explicitly referred to colloquially as “bridge notes,” signaling the expectation that the investment was being made in advance of a progressing or at least near-term equity financing. (They have since taken on a more enduring character.) Finally, typical convertible note events of default are minimal, often do not contain a more familiar higher post-default rate of interest (or any other consequence) and are not by their nature even capable of falling into default in the first place. For example, notes that by their terms do not amortize or pay interest until maturity or conversion can not become subject to a payment default.

The second interpretation is more interesting. The lack of evidence of any bargaining by angel investors in exchange for the inherent concessions of the SAFE as compared to the convertible note structure suggests that entrepreneurs are systematically underpricing their angel rounds. I have always found it curious that no matter who, what, how, or where, convertible note terms tend to (at least initially) converge around a “market” discount and conversion cap, with little resistance from investors, who merely confirm that these metrics conform to “market” terms. An interesting experiment might be to reverse the typical sequence of the conversation. Instead of starting with a proposal for convertible notes and then transitioning to a SAFE structure, what if startups took the approach of saying: “well, we can go with the convertible note structure, but we want a lower discount and higher cap than what you proposed in the SAFE structure.” The irony of this whole episode is that, while SAFEs may be presented as a more founder-friendly approach to a convertible note round, the reality is that the introduction of the SAFE structure may reveal that founders have miscalculated their value proposition to the market all along yet never realized it. At the very least, the market’s reaction to SAFEs offers founders a thesis that they should consider testing. 

 

[1] That said, investors may want to consider the implications for the five year holding period needed to qualify for the Small Business Stock Gains Exclusion under Section 1202 of the U.S. tax code.

[2] The IRS has not confirmed such a treatment, but it would be analogous to the sale of a warrant.