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Why We Should Call SAFE Notes "VC Options"

In recent year there's been a growing trend towards the use of SAFE (Simple Agreement for Future Equity) notes instead of traditional equity investments. While SAFE notes have been touted as a simpler and more founder-friendly alternative to convertible notes, We could argue that we should actually be calling them what they really are - "VC Options." The key feature that makes SAFE notes akin to VC options is the fact that they give venture capitalists (VCs) the right, but not the obligation, to purchase equity in a startup at a future date and price. Much like a stock option, a SAFE note provides the holder (the VC) with the ability to "exercise" their right to convert the SAFE into shares, typically at a discounted price or with a valuation cap.

Let's look at an example to illustrate this point:

Imagine a startup raises $1 million through the issuance of SAFE notes. The SAFE notes have a 20% discount and a $10 million valuation cap. This means that when the startup raises its next round of financing, the SAFE holders can convert their notes into shares at a price that reflects a 20% discount to the new round's valuation, or at a price that values the company at $10 million, whichever is lower. Now, let's say the startup subsequently raises a $5 million Series A round at a $20 million pre-money valuation. The SAFE holders can then convert their $1 million investment into shares worth $1.25 million (based on the 20% discount), or shares worth $1 million (based on the $10 million valuation cap), whichever is more favorable to them. In this scenario, the SAFE holders have effectively acquired a "VC option" to purchase equity in the startup at a discounted price, similar to how a stock option gives the holder the right to buy a stock at a predetermined price in the future. The key difference, however, is that with a traditional stock option, the holder has to actively exercise the option and pay the strike price in order to acquire the underlying shares. With a SAFE note, the conversion happens automatically, with the holder simply receiving the corresponding number of shares based on the discounted price or valuation cap. This creates an interesting dynamic where the SAFE holders have a significant advantage over the startup's common shareholders. The SAFE holders can essentially "wait and see" how the company performs, and then decide whether to convert their notes into equity at the most favorable terms. In contrast, the common shareholders have no such optionality - they have already committed their capital to the startup and their upside is entirely tied to the company's performance. This is why we should start calling SAFE notes what they really are: "VC Options." By framing them in this way, we can better understand the asymmetric risk and reward profile they offer to venture capitalists, and the potential dilution they can create for common shareholders.

The Evolution of SAFE Notes

As the use of SAFE notes continues to proliferate in the startup financing landscape, it's likely that we'll see further developments that strengthen the analogy to traditional stock options. Possible development could be the introduction of "exercise windows" for SAFE note conversions. Rather than allowing automatic conversion upon the next financing round, SAFE notes could be structured to only be convertible during specific time periods or upon the occurrence of certain triggering events. This would further cement the analogy to stock options, where holders typically must decide whether to exercise their options within a predetermined timeframe. It would also give founders and common shareholders more predictability and control over the dilutive impact of SAFE note conversions. Additionally, we could see SAFE notes incorporate more elaborate pricing mechanisms, such as the use of "strike prices" or "exercise prices" that are tied to specific valuation thresholds or financial metrics. This would create an even more direct parallel to traditional stock options, where the holder pays a predetermined price to acquire the underlying shares. These types of developments would likely make SAFE notes even more attractive to venture capitalists, as they would further enhance the optionality and risk-reward profile of these instruments. However, they could also exacerbate the power imbalance between SAFE holders and common shareholders, potentially leading to even more significant dilution and inequitable outcomes for founders and earlier stage investors. Ultimately, the evolution of SAFE notes towards a more option-like structure highlights the ongoing tension between the interests of institutional investors and the long-term health of the startup ecosystem.

As these instruments continue to evolve, it will be crucial for founders, investors, and policymakers to carefully consider the implications and work towards more balanced and equitable financing solutions. By recognizing the inherent "VC Option" nature of SAFE notes and proactively addressing the potential pitfalls, the startup community can ensure that these financing tools are used in a way that promotes sustainable growth, shared prosperity, and a thriving entrepreneurial environment.

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