At Kinfolk, we regularly feature articles from people around the world whose perspectives we believe are important and valuable. Our aim is to help demystify the process of building enduring technology businesses for African founders and leaders.
In this article, renowned venture capitalist Fred Wilson criticizes the use of Simple Agreements for Future Equity (SAFE) notes and convertible notes as a means of raising seed capital in the startup industry. Wilson argues in his blog post that these funding mechanisms, which defer valuations and dilutions until later, hinder transparency in ownership and can create confusion about ownership amounts at key decision points.
Wilson suggests several ways to address this problem, including the use of a maximum limit for the number of notes issued, recommending that founders use lawyers to produce a cap table at closing, and advocating for the return of priced seed equity deals as a more suitable mechanism.
Here's a brief of Wilson's thoughts...
I was reminded of how much of a shitshow raising seed capital via SAFE notes is. So I thought I’d repost the crucial parts of a post I wrote on this topic a couple of years ago.
I have never been a fan of convertible notes. USV has made quite a few convertible and SAFE notes. We are open to convertible and SAFE notes and will not let the form of security the founder wants to get between us and investing in a company we like.
But convertible and SAFE notes are not in the best interests of the founder(s).
Here is why:
They defer the valuation issue and, more importantly, dilution until later. Dilution is too essential to delay for even a second.
They obfuscate the amount of dilution the founder(s) is taking. A founding team should know how much of the company they own every second of the journey. Notes hide this from them, particularly the less sophisticated founders.
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 happens. This is the worst thing about notes, and doing more than one is almost always a problem in the making.
They put the founder in the difficult position of promising an amount of ownership to an angel/seed investor that they cannot deliver down the round when the notes convert. 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 own a LOT less than they thought they did. And they blame the founder(s) or us for it, and it is honestly not anyone’s fault other than the foolish structure (notes) they used to finance their company.
The Series A-focused VC firms that often lead the first-priced rounds get to see this nightmare unfold all the time. The company has been around for a few years and has financed itself with various notes at various caps (or no caps), and finally, the whole mess is resolved, and nobody owns anywhere near as much as they had thought. Sometimes we get blamed for leading a dilutive round, but I don’t care so much about that; I care that we are allowing these young companies to finance themselves in a way that will enable such a thing to happen.
Here are some suggestions for the entire angel/seed sector (founders, angel investors, seed investors, lawyers):
Do priced equity rounds instead of notes. As I wrote seven years ago, the cost of a simple seed equity deal has come way down. It can be done quickly for less than $5k in a few days, and we often do that.
The first convertible or SAFE note issued in a company should have a cap on the number of notices issued. A number like $1mm or a max of $2mm sounds right.
Don’t do multiple rounds of notes with numerous caps. It always ends badly for everyone, including the founder.
Founders should insist that their lawyers publish, to them and the angel/seed investors, a “Pro-forma” cap table at the closing of the note that shows how much of the company each of them would own if the note converted immediately at different prices. This “Pro-forma” cap table should be updated every time another note is issued. Most importantly, we cannot and should not continue to allow founders to give notes to investors and not understand how much dilution they are taking on each time they do it. This is WRONG.
Honestly, I hope the whole scourge of notes goes away, and we can go back to how we did things for the first twenty years I was in the venture capital business. It would be a better thing for everyone. But if we can’t put the genie back in the bottle, we can at least bottle it up better because it causes many problems for everyone.