Here's why VC Fred Wilson say safes are bad for startups

Prominent venture capital investor Fred Wilson published a blog post that called safes, a popular type of funding among seed stage founders and investors, a death trap.

Safes, which stand for simple agreement for future equity, were created by startup accelerator Y Combinator in 2013 as an alternative to debt financing through convertible notes.

Entrepreneurs looking to raise pre-seed or seed rounds commonly use the safe as simple equity financing without defined terms, which is something Wilson said can be disastrous for early companies.

Here are the good and bad things about safe note financing, and why it's become such a hot-button topic among early stage startups.

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Silicon Valley's venture capitalists are arguing about money.

They're not squabbling about whose startup is worth more, or whose fund posted better returns. The source of strife is something called a “safe,” a specialized type of investment in early-stage companies that has become increasingly prevalent in recent years, much to the dismay of some longtime VCs.

One of these VCs, prominent investor Fred Wilson, went on the attack last week and called safes fundamentally flawed and unfair to founders.

“I was reminded yesterday how much of a shit show raising seed capital via SAFE notes is,” Wilson wrote in a blog post.

Though he did not provide details about the specific incident that earned his ire, Wilson re-published an earlier post of his outlining his case against safe notes.

“They can build up, like a house of cards, on top of each other and then come crashing down on the founder(s) at some point when a priced round actually happens,” Wilson wrote.

The debate may seem esoteric and parochial, but it has big implications for the startups vying to become the next Facebook and for the entrepreneurs putting everything on the line for a promising business idea.

So what exactly is a safe, and why are the Valley's VC feuding about it？

Safe funding deals are quicker and simpler than convertible debt

Safe stands for simple agreement for future equity. It is basically a promise that an investor has the right to purchase a startup's shares at a fixed price at some point in the future in exchange for providing the startup with funding today.

The safe was created by startup accelerator Y Combinator's Carolynn Levy in 2013 as an alternative to convertible notes. The difference is that the safe is pure equity, whereas a convertible note is “fundamentally a debt instrument,” according to Levy.

Convertible notes are a form of debt financing that act similarly to loans and are considered relatively complex, lengthy legal agreements. Convertible notes carry interest that a founder needs to pay back to the borrower — the investor — once they exercise the options, typically in the Series A round following the seed funding, either in the form of additional shares or in cash repayment.

Around 2013, it was clear that entrepreneurs and potential investors were looking for a simpler way to secure funding without all the risk that comes with debt financing. So Levy introduced the safe, an alternative that promised investors shares and partial ownership of the company in exchange for funding.

“The safe converts based on the occurrence of an event, whether it's an equity financing or a change of control transaction, in which case the money invested converts into shares of stock (or may convert into the right to receive cash, as can happen in the change of control),” Levy told Business Insider via email.

The turnaround on a safe is much quicker than convertible notes or other, more traditional forms of financing because important details like valuation and how much of the company the founder owns are essentially punted to later funding rounds. A typical safe checks in at around only five pages, according to Y Combinator.

Now, they're all the rage among many startups and VCs.

“Pretty much 100% of YC's founders raise money on safes so I haven't really thought about convertible notes in a while,” Levy said.

Unpleasant surprises down the road

But not everyone shares Levy's enthusiasm. That's because the things that make safes so quick and easy can become problems down the road.

In particular, these safe investments don't address the startup's valuation and the dilution a founder takes to make space for the investor, issues that get tricky if all parties aren't on the same page during initial talks. A founder may not realize exactly how much of their company they have signed away.

“When these notes convert, the math can be surprising and complex if there are multiple caps, making founder ownership incredibly hard to understand,” Trae Vassallo, founder of early investment firm Defy.vc and Kleiner Perkins alum, told Business Insider.

For that reason, Vassallo says, her firm encourages entrepreneurs to set fixed terms on all rounds, even in the early days.

Wilson noted in his post that his firm, Union Square Ventures, has done both equity and debt financing, and that the founder's choice of funding strategy wouldn't stop the firm from investing in a company they are interested in.

But he believes that the problems that come with safes outweigh any benefits.

“They put the founder in the difficult position of promising an amount of ownership to an angel/seed investor that they cannot actually deliver down the round when the notes convert,” Wilson wrote. “I cannot tell you how many angry pissed off angel investors I have had to talk off the ledge when we are leading a priced round and they see the cap table and they own a LOT less than they thought they did.”

For her part, Y Combinator's Levy says some of the criticism is due to the novelty of safe notes and the perceived risk compared to debt financing.

“I'm sure there are investors (particularly non-Silicon Valley investors) who prefer notes because they are more comfortable with debt – if something goes wrong at the company, an investor with a note is treated as a creditor, and creditors take before stockholders in the event of a dissolution,” Levy said.

But Wilson says he'd rather move away from convertible and safe notes and return to the VC industry's traditional equity financing model, with lawyers, fixed terms, and transparent dilution so a founder knows exactly what they've signed up for.

“As I wrote seven years ago, the cost of doing a simple seed equity deal has come way down,” Wilson wrote. “It can easily be done for less than $5k in a few days and we do that quite often”