YC legal team here: first, we agree that if you have legal counsel, you should get their advice on how to handle. Second, other startups have had this happen to them and it's typically easily resolvable.
The first line of the safe states "in exchange for payment by [Investor] of [$], on or about [date of safe] ... ." We drafted this line specifically to ensure that the parties understand that money MUST be exchanged for the safe to be valid. Without payment there is no "consideration," which means there is no valid contract.
We decided that picking a hard date for "expiration" of an unfunded safe creates its own set of problems, so the safe is effective "on or about" the same date it is signed. Opinions can differ on the distance between "on" and "about," but we think its reasonable that "on or about" means just 1-2 days. Investors should not be signing safes if they don't have the money to invest within that time frame.
A suggested course of action for OP's situation is to send the investor a written notice that the safe is terminated because there was no exchange of money on or about the date the safe was signed, as provided in safe. Take steps to ensure the notice is sent to whatever contact addresses you have for the investor (email, physical, email of the investor's legal counsel (if there is one). Keep a copy of the written termination notice and proof that it was sent.
Then probably best not to do business with that investor again!
Many other larger value transactions of this nature do have an execute by date actually baked in. So while no contract exists without consideration, a real estate, business acquisitions etc often have a closing date associated with the agreement (which can of course be modified). I've liked this on transaction side (not a lawyer). What are difficulties with having a time frame to perform within?
Ie, safe must be funded within 2 business days of date of safe. Can always do a new safe if the first doesn't go through and you still want to do business?
It's fine that you aren't incorporated yet, and I'm glad you waited! Many applicants have not formed a legal entity when they apply. If you are accepted in the S17 batch, we will help you incorporate in the US.
Y Combinator purchases common stock - approximately 6%. Y Combinator has a fund, called YCVC Fund I, that purchases a safe equal to 1% of the company (at the time of issuance of the safe). The safe is typically convertible into shares of the issuer's preferred stock (but could convert to common stock in a merger, for example). So between the two YC entities, that's 6% in common stock and 1% in a convertible security that will most likely turn into preferred stock. Hope that helps clarify!
We look for great founders and great ideas, regardless of geography. BUT...if you get accepted, your company will have to convert into a US domestic corporation (preferably Delaware). So forming your entity now in Europe or North America may end up being a waste of time and effort.
Re question 1: you read correctly. An investor just get its money back in a change of control. An investor using this form of safe would have to be very confident that the safe would be amended to match a later safe with better terms. To be perfectly honest, this form of safe may not be very popular for this reason, but uncapped notes with an MFN clause have been popular, so we decided to have a safe like that too.
Re question 2: if the company has drafted its IRA to exclude the safe holders from pro rata rights, then the company must give those rights via side letter instead. Many investors feel very strongly about pro rata rights, so we drafted the safe to ensure that the company had to give them, but with some flexibility as to where (e.g., in a side letter rather than in an IRA).
Aha. It seems odd then to say that there are two choices in the case of MFN conversion, when they amount to the same thing.
I know YC has seen MFN usage in the "everyone gets $100k" scenario, but I also could see them useful for family and friends rounds where an unsophisticated investor with a conflict of interest wants to put in the first $10k but not set a price. In that case, a default conversion might make sense as an option.
The SAFE Preferred Stock would be whatever you end up calling it in the charter - for example, Series AA (just something to differentiate it from the preferred stock being issued to the new money investors). So no, you would not actually call it "SAFE Preferred Stock" in your COI. Does that make sense?
I think with this idea you end up back at the note concept; what you are proposing sounds more like a loan / debt to me (if I understand you correctly?). The purpose of the safe, anyway, is to turn investors into stockholders at some point.
Well a debt/loan without a term, more like an uncallable zero coupon bond without a maturity date, rather it has a maturity 'condition'.
As you have clearly pointed out, one of the bigger issues with convertibles is that they change over time in terms of their impact on the company. The SAFE fixes that by getting rid of the debt/loan aspect, and this would do the same but bake in a fixed redemption price.
An example, you get this thing (lets call it a BOOST), which is $100K with a redemption price of $125K. Now you startup goes 18 months, then does a series A raise for 1.125M$. They redeem the BOOST for 125K, pocket the $1M, and their series A investor gets their chunk of preferred. The 'rate' on our BOOST then is 25%/1.5years or 16.6% APR.
Example 2. Same deal except the series A comes 6 months later. Now the redemption in only 1/2 year gives an effect return of 50% APR.
Example 3. Company starts, grows to a going concern, runs for 5 years and then gets bought by BigCorp, and the BOOST is redeemed. Now its effective APR is 5% (actually less than that if you're not doing simple interest etc but it illustrates the point doesn't it?)
Example 6. Startup goes poof and dissolves. BOOST is effectively at the head of the line on distribution of the asset value.
Take $100K, divide it into $10K chunks, spread it across 10 different BOOSTS with other investors in them and spread the risk still further.
So the Series A investors would essentially be cashing out the BOOST investors? I don't think any Series A investor would go for this. They want to see all the money go into company growth at that stage.
"So the Series A investors would essentially be cashing out the BOOST investors?"
Yes. But lets look at it from a couple of different perspectives before we conclude they won't like that.
First we'll assume that the Series A is much larger than the BOOST redemption cost, anywhere from about 10x to 20x. We make that assumption because it the BOOST aka "seed" round is much bigger than that the Series A looks more like a Series B than a Series A, which is to say the company valuation isn't really in a place where VCs would jump in ok?
Lets put some numbers down which makes talking about it easier.
Lets say the Series A really is 9X the BOOST so in a post money valuation with 60 percent for the company founders/employees we're looking at a cap table that is
So in the left scenario everyone stays in, and in the right hand scenario the Series A investor has effectively "bought out" the BOOST investor. (the money flow is different but the effect is the same). Lets assume that value post money was $5M.
Company value increases 5x and the company is sold for $25M.
Series A guy in the left scenario gets their liquidation preference + 36% of the remains (with participation) whereas in the right scenario they get their liquidation preference + 40% of the remains (again with participation) in the second scenario.
If the company is going to do well (and they assume it will) they do better by not having the BOOST guys in the cap table then they do with them there taking a percentage. If the company does poorly they still lose their same investment they would have lost anyway.
Things are simpler for the BOOST guy too, instead of managing dozens of small share holdings in small companies they get a smaller but faster return. This creates a reliable source of seed money for the ideas, which creates a larger pool of potential Series A investments for VC companies.
The notes have proliferated because they are quick and easy (no transaction costs, etc.) so it's the way many startups like to raise money. Priced rounds are fine too - they just tend to take more time and involve costs. YC and others have open-sourced streamlined equity financing documents, but so far, nothing has been as easy as raising on a convertible note.
clevy, I literally said in my comment I understand the advantages of notes. I don't need to be convinced. Notes are great.
My question is different - to what extent investors find note financing acceptable/appealing? Is it only YC companies that get the privilege? Is it a Silicon Valley thing, not used much elsewhere (like Seattle)? Is it used everywhere, and I just happened to be unlucky with it?
Sorry, DenisM. Investors in the Silicon Valley find notes very acceptable. It is not only YC companies that raise early money on notes, many other companies do too. Notes may be the most popular in SV, but I am sure that investors in other places use them as well. I think maybe you just got unlucky.
I can tell you the majority of angel investors in Dallas I've talked to that do not have experience with west coast deals do not like convertible notes.
We closed a note with Dallas investors that DID have experience w/ west coast deals that featured a cap and a discount.
This is a high class problem to have! As mentioned above, this seemed to us to be an extreme corner case. To remain simple, we tried not to draft for every scenario (which was hard, believe me - lawyers do this by nature). It may require some patience on the part of the safe holder, but odds are that eventually a company will have a liquidity event.
My company is in one of these corner cases where we haven't converted our debts but still operate with a small, but growing revenue stream. It's possible that I will be able to repay the debts with interest in 2-5 years depending on how well we invest revenues in growth and part-time development. I wonder if it isn't more beneficial for me to have the option of paying back debts from revenues and then use revenues to pay out dividends to shareholders and more beneficial for investors to be able to call on the debt when it comes due if the company has accumulated enough revenues. With a safe, both parties seem to lose leverage over the other. I realize that startups in my situation are probably already a write-off from the investors' perspective, so perhaps it's just cheaper to ignore them, but I could imagine a number of people raising $100K safes ending up with an app that makes $30K per year and investors just get screwed.
The first line of the safe states "in exchange for payment by [Investor] of [$], on or about [date of safe] ... ." We drafted this line specifically to ensure that the parties understand that money MUST be exchanged for the safe to be valid. Without payment there is no "consideration," which means there is no valid contract.
We decided that picking a hard date for "expiration" of an unfunded safe creates its own set of problems, so the safe is effective "on or about" the same date it is signed. Opinions can differ on the distance between "on" and "about," but we think its reasonable that "on or about" means just 1-2 days. Investors should not be signing safes if they don't have the money to invest within that time frame.
A suggested course of action for OP's situation is to send the investor a written notice that the safe is terminated because there was no exchange of money on or about the date the safe was signed, as provided in safe. Take steps to ensure the notice is sent to whatever contact addresses you have for the investor (email, physical, email of the investor's legal counsel (if there is one). Keep a copy of the written termination notice and proof that it was sent.
Then probably best not to do business with that investor again!