In earlier posts here and here, we have discussed convertible debt, which remains a popular pre-equity funding path for early stage companies. However, in recent years, alternatives to convertible debt have emerged that offer certain benefits over traditional convertible debt instruments in terms of simplicity, speed and cost. These instruments are sometimes referred to as “convertible equity,” and the two most popular convertible equity documents are the SAFE (Simple Agreement for Future Equity) and the KISS (Keep It Simple Security). A primary driver of these alternatives is the simplicity of the instruments; they are intended to reduce the issues to be negotiated and provide a simple set of documents to help get the deal done with as little deal cost as possible.
Developed by West Coast accelerator Y Combinator, the SAFE is similar to convertible debt as its terms generally end up being dictated by the terms and preferences of the company’s next preferred stock financing. However, because it is not a debt instrument, it does away with a number of the debt-specific components found in convertible notes, such as accrued interest, default and maturity provisions. Many industry participants view this as an advantage of the SAFE, as these debt-specific concepts really don’t reflect the underlying purpose of the convertible note. That is to say, investors generally do not purchase convertible debt with the goal of accruing interest or seeking repayment of the principal investment upon a specified maturity date – they purchase them with a view towards participating in the company’s next preferred equity round and becoming a preferred stockholder of the company.
The SAFE provides a simple vehicle by which to accomplish this goal, with minimal negotiation required between the parties. The document drafted by Y Combinator takes a “down-the-middle” approach that is intended to be generally fair to both parties, and because it does not accrue interest or require repayment on a specified maturity date, has only two main points to be negotiated once the parties agree on the investment amount: the inclusion and amount of a valuation cap and the amount of the conversion discount. The valuation cap, if included, essentially sets a ceiling on the valuation of the company at its next preferred stock round for purposes of the SAFE investor’s conversion, so that the SAFE investor’s investment cannot be diluted below a certain equity percentage of the company. The discount operates in much the same way as the convertible note discount we discussed in our prior post, allowing the SAFE investor to convert its SAFE investment at a discounted per-share price relative to the preferred investors participating in the round.
Because the SAFE is a relatively simple, down-the-middle document that allows companies to minimize transaction costs in connection with an early stage investment, it has grown in popularity significantly over recent years. However, some large institutional investors and corporate partners have criticized the SAFE for a perceived lack of investor protection – for instance, a SAFE isn’t debt (at least as far as a lawyer views debt) and thus has no repayment timeline if the company does not close a future equity rounds. As a result, 500 Startups released the KISS in July of 2014 in an attempt to capture the simplicity of the SAFE, while offering certain downside protections standard in most convertible note financings that are absent from SAFE transactions.
Unlike the SAFE, the KISS has a maturity date after which the holder may convert its investment amount into a newly created series of preferred stock of the company. This strikes an appealing middle ground between the SAFE and traditional convertible note features. The KISS documents also offer a version that accrues interest, further mirroring features of convertible debt. So while the KISS offers certain features and additional protections sought by large institutional investors, a number of these features come at the cost of reintroducing convertible debt concepts that the SAFE was designed to avoid in the first place (maturity date, accrual of interest, etc.). As a result, the savings in transaction costs enjoyed by a SAFE financing are somewhat mitigated by the use of a KISS, as the latter includes more provisions that are subject to negotiation, and thus can often result in higher legal fees and a longer process.
Both SAFEs and KISSes may have their place in a pre-equity financing plan, as the SAFE generally presents a more attractive option for earlier stage companies and smaller investments, while the KISS is more appealing to investors who are more willing to pay higher transaction costs for additional protections. Probably the biggest advantage of each is that they are simple documents that reduce transaction costs compared to negotiated convertible debt rounds.