When it comes to raising capital to get your new business off the ground, there’s a range of investment structures available, from common stock to exchangeable shares. One of the newer and most popular forms of financing for startups is convertible equity.
When raising an angel or seed round of financing, many startups increasingly opt to offer investors some form of convertible equity rather than more-traditional convertible notes, which require the company to repay the investment plus interest if the company is unable to raise future rounds. Convertible equity, on the other hand, removes the stress of possible repayment with interest, and gives the company the potential of starting out free of significant debt.
Two of the most popular forms of convertible equity are alternative investment vehicles called the SAFE and the KISS. Both are designed to give startups an easy way to obtain initial financing when traditional means of investment might not be available.
Playing it SAFE
Created in late 2013 by Y Combinator, a Silicon Valley-based technology accelerator known for helping get startups off the ground, the simple agreement for future equity (SAFE) is a brief investment document that, as its name suggests, offers a simple way for investors to provide funding to early stage companies. The goal was to avoid the drawn-out negotiations and lengthy paperwork that can often serve to hinder the investment process, by creating standard, pre-agreed terms and conditions that govern the investment.
The core structure of the SAFE is that investors provide funding to companies in exchange for the right to obtain equity in the company down the road. The investment converts to equity upon a specified future event, typically when the company raises some amount of equity funding in a later financing round.
The SAFE differs from convertible notes and other traditional debt instruments in a number of key ways. First, there’s no maturity date, meaning that the investment might never become equity, and no repayment is required. Second, the amount of funding provided via the SAFE accrues no interest that needs to be repaid or added to the total investment amount in the event it does convert to equity.
One of the biggest reasons why SAFEs are so popular with startups is that the major terms of the financing are deferred until a future date, making it easy to get your hands on funding relatively quickly and cheaply. No time and expense are lost in trying to determine the company’s worth for investment purposes, which is particularly helpful since startups and early-stage companies can be notoriously difficult to value. Instead, such negotiations and valuations can be put off until a subsequent financing when there’s more information available, at which point the money invested via the SAFE simply converts to equity on the later-negotiated terms.
The obvious downside for investors is that they need to be comfortable with a degree of uncertainty. SAFEs lack many traditional investor protections and are subject to later negotiations over which the early-stage investors have no control. There’s also no guarantee as to when any subsequent equity financing round might occur, meaning that it could be a while until funders see their investment turn into equity (if ever). Given the minimal investor protections that SAFEs offer, investors may want to use their negotiating leverage to demand that their investment be structured as a traditional convertible note or a KISS (see below).
KISSing the SAFE Goodbye?
The introduction of the SAFE undeniably changed the convertible equity landscape. However, some were uncomfortable with the lack of investor protections that it offered. As a result, another accelerator, 500 Startups, introduced the Keep It Simple Security (KISS) in mid-2014.
In addition, 500 Startups has created 2 versions of the KISS: one that includes debt-like features, like a maturity date and the accrual of interest, and one that doesn’t. In the debt version of the KISS, upon maturity, investors are offered the option to convert the original amount of the investment, plus any accrued interest, into preferred stock in the company.
Because of these features, many in the financial world view the KISS as a middle ground between a convertible note and a SAFE. The KISS was essentially designed to offer an alternative investment vehicle that’s not only simple (as the name suggests), but also balanced to benefit both companies and investors. In addition to debt-like features like maturity dates and interest rates, KISSes can also offer other investor protections such as rights to information and the ability to participate in future financings of the company.
While both SAFEs and KISSes have enjoyed high levels of popularity since their introductions a few years ago, it remains to be seen whether they’ll continue to be in frequent use during angel and seed rounds, or if an alternative investment structure will emerge that offers even more attractive features.
Either way, for the time being, SAFEs and KISSes remain a highly attractive option for startups to accrue capital. By removing the time-consuming and costly negotiations associated with many traditional forms of investing, these convertible equity structures have opened the door to easier early-stage financing, thereby offering a bridge to help get companies to later financing rounds.
© 2017 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.