Years ago, Y Combinator helped popularize the convertible note as a way for startups that go through its accelerator to easily raise seed money. That gave companies the flexibility to get cash quickly without having to worry about hiring lawyers and pricing early funding rounds. Now the accelerator is moving to a new convertible equity model with an investment instrument that it’s calling “Safe,” which stands for “simple agreement for future equity.”
The headline, of course, is that Y Combinator is moving off convertible notes, but the truth is a little more nuanced than that. Yes, Safe does away with some of the hassles that come with using debt as an investment instrument.* But at the end of the day, “Safe” investments operate in basically the same way that convertible notes do.
That’s actually by design. From an investment perspective, not much has changed, according to Y Combinator partner (and lawyer) Carolynn Levy. The accelerator wanted to provide all of the upside that convertible notes offer — mostly the ability to raise money quickly without having to hire a lawyer and spend weeks negotiating terms — but while steering clear of the less attractive issues associated with them.
“People are slow to adopt change, and you don’t want to throw something too crazy at them,” Levy said. “Once they get past the name, they’ll see the same thing is going to happen with convertible notes.”
The two main problems that Safe seeks to solve are the issues of dealing with accrued interest and maturity dates. On the latter end, maturity dates on convertible notes tend to be one year, since they’re issued as short-term debt. But a year comes up fast, and that can be a distraction and a hassle for startups.
The other issue Safe seeks to do away with is accrued interest on the convertible debt they issue. While it’s mostly just a hassle for startups to figure out how much interest they have due upon conversion, Levy says occasionally there are investors who ask for a high interest rate. Instead of treating their investment like a short-term loan, moving to Safe will ensure that all investors are really in it for the equity upon conversion.
“In the securities world, there’s debt and there’s equity,” Y Combinator partner Carolynn Levy told me. “But if everyone wants to own equity in a company, why would you use debt as an investment instrument?”
While Levy joined Y Combinator about a year and a half ago, she was part of the team at Wilson Sonsini that helped draft Y Combinator’s standard series AA equity financing documents back in 2008, and also helped with the standard convertible note documents that the company offered to its startups three years ago.
Now, the folks at Y Combinator are hoping to offer Safe in the same way, with a set of standard, open source documents that anyone can use.
Y Combinator isn’t the first group to suggest a new convertible equity as an alternative to convertible debt. Adeo Ressi’s TheFunded and Founders Institute, in conjunction with Wilson Sonsini, issued a group of standard convertible equity documents back in the summer of 2012.
But having the backing of Y Combinator might help popularize the investment instrument, in part because all companies that go through the accelerator will begin using Safe, starting with the upcoming Winter 2014 class.
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* For those who want to geek out, you can find a more thorough discussion of the pros and cons of convertible notes here and here.