Jon: There's a spare bed if you wanna stay here. Peter.
Peter: you're inviting me to stay the night, John.
Jon: I can't guarantee the sheets. The sheets have been washed within the last six days of use.
Peter: Sweet. I'll go home smelling like curry.
Jon: We have an extra spare set of sheets if you need to.
Peter: I'm kidding. I'm getting. I'm got my car. I'll drive me.
Jon: Home. Well, that racist. We better cut that. Cut that guy's got that nose. Fine, I guess. Is that racist?
Jon: That's not racist. I don't know. I just get so nervous in 2023.
Peter: that. I say that like, I'll go home smelling like curry. Your house smells like curry. Does this in my career. Yes.
Peter: Because it's not racist. This is what it is. Like. Your house smells like it's got a bad thing.
Jon: So we can leave this in like after So Gunjan’s in India. That's my wife and her parents were here.
Peter: And they eat a lot of curry.
Jon: And it doesn't smell like curry to me anymore.
Peter: Yeah, cause you're.
Jon: Used to it. I mean, when I come home, it isn't like curry. It used to be. I'd be like, they're cooking. Smells amazing. I'm just like, it's. It smells like it always does. But you're saying there's a strong curry smell? Yes. I've been to India like, 27 times. I go about every other month. I'm a big I spend a lot of time in India.
Peter: Like my house probably just smells bad. Years at least just smells like curry. And you're used to it. I mean, house prices smells bad, and I'm used to it.
Jon: Okay. All right. Let's begin. So let's talk about Peter wanted to talk about the downsides of say it. So him and I have a WhatsApp chat that we go around and then between ever recording sessions every 2 to 6 weeks, we just say, Let's talk about this, let's talk about this. And one of the ones he wants to talk about are what are the downsides of a safe?
Jon: A safe is basically the acronym. It stands for a simple agreement for Future equity. It became really popular with Y Combinator. I think if you look at the last ten years, the trend was investors did a price round, which means, hey, we're going to give you 2 million, we're going to value the company at 10 million. And so we're going to then take two divided by 12.
Jon: And whatever that calculation is, that's the percentage that we're going to own is what VCs did. And then the challenge that we faced is that the amount of legal and accounting cost to close that deal was high.
Peter: It was like ten, 20 grand.
Jon: Ten to agree on. But I don't know. I don't know that May I've always thought that was high. Maybe it wasn't high. Two years of.
Peter: You know, I think it's high.
Jon: Depending on the size. Then came the concept of convertible notes. So convertible note was basically it's just a debt, it's a note, It's like a loan. It's a loan. At the end, the investor can say, I want I can either have this paid back or convert to equity at a future date, and it's either the company's choice or the investors choice.
Jon: And that typically has an interest rate attached, usually 7 to 10%. Yeah. And it would have a discount of, say, 20%. So let and maybe a cap. So like let's say you raised a 10 million valuation, your cap might have been 8 million, which means then you would have come in at that lower valuation compared to new investors.
Jon: And so it also allows you to kind of kick the ball down the road of, Hey, if Peter wants to invest in my company, I don't have to argue what I think it's worth. We're just going to put some general metrics so that way he gets a discount to the next round, he gets an interest rate and that was the very popular thing for a while.
Jon: And then along came saves and saved, basically gets rid of the discount, right? And it gets rid of the interest rate as a general rule. But I'll say that it's.
Peter: Fair he still keeps the discount. So the idea, well, there's no interest. So there are a couple of attorneys that joined Y Combinator and they were tasked with like, Hey, we need it. We need an easier, faster, cheaper way to help companies raise money. And so they created the save. And the idea was they wanted to create an equity security.
Peter: And they're very clear about this. I mean, you read about it in the history of saves and so forth, then they're like, saves our equity, right? They are not. They are not debt. And because they are not debt, they don't have an interest rate. I mean, if you think about like debt in its purest form, debt is simply like renting money from somebody else.
Peter: Right. I've got I've got this money, I'm going to let you borrow it. Right. And you're going to pay me some rental income on that money you're borrowing and is paid in the form of in the form of interest and and the safe. Because it's not dead, it's equity. It doesn't make sense for it to have an interest rate.
Peter: It's like you're not paying for that money. Right. Like you don't owe the money back at the end of the day. Now, if the company goes bankrupt or sells for a certain number, the safes are written so that they can sort of pay back first before equity does. But even that's a little bit nebulous. so yeah, I mean, what's interesting though is that like there are some problems with safes, so on the plus side, with a safe.
Jon: Return by the founder of the is.
Jon: Bar. So this is for both.
Peter: This is like for both. So like look on the plus side of a safe, you don't need an attorney to raise a safe I mean the docs the docs are on my commentary website downloadable you just download them right And it even says in the docs it's like every like you can refer back to the Y Combinator term sheet that's on our website.
Peter: Everything should be the same except for and then you can add anything changes you want to make, right. So it's it's very clean, very easy, it's very well understood. You basically like just fill in a few boxes and you're done right. Like what's your discount rate, what's your cap, what's the amount, who's who's investing And you're done right.
Peter: Like it very simple cost nothing effectively. Right to do And so like and because of that it's also super fast. And the other thing that's nice is you can have multiple safes sitting out there at multiple valuations and so on and so forth. The problem with that though, is that they can be like people will think, I've raised all this money and say when I did a different valuations and have no clue what they're ending, ownership is going to be both the investors and the founders of the company.
Peter: And there have been many instances where like these founders, they raise all a bunch of these safes and they're all floating out there. And if they're not like keeping track of them really closely, like, you know, they might, you know, miss out on some or miss, you know, misremember where certain one said or what have you. And even if they do track all of them, it becomes really complicated because if if they come in at different caps and different discounts, when you raise that round, they're going to impact your they're going to impact you from a dilution perspective and, you know, in varying ways that kind of impact each other.
Peter: And it gets the math gets kind of complicated and convoluted until you actually raise the price round. And so as a founder, you don't really know how much of the company you own. And for an investor like one of my biggest concerns was save some. I don't particularly love them is because I feel like you're taking all of this risk and you're not really getting compensated for it because there are there are other instances that I've heard of where the company and you still have the same problem.
Peter: It's convertible notes, you know, unless you adjust the terms accordingly. And same with safes. But where like the company raised a bunch of money in sales and because they never converted it into actual equity, they didn't raise any more money. And they went back and they basically paid back all of the investors, the money in their safe, and they didn't even get the interest because there's no interest on these.
Peter: Okay. And so the VCs, the investors, the angels, you know, whoever, they basically got their money back out of the deal and didn't participate in any of the upside. And so as an investor, like, I don't know, I think that's a real risk that you have to be aware of is like, Hey, you were all excited. You finally got, you know, you made 50 investments, 49 of them went to zero.
Peter: You finally had that one that was successful. And then they never convert and they come back and they pay you off and you get nothing.
Jon: So the example that the most well-known one that I know, the other one is top Toptal. Yeah. And they had convertible notes, not safes. Yeah, they created a company. I don't know what it was worth, the multiple billions. Andreessen Horowitz You know, one of the top ten V.C. firms is in it.
Jon: And all they walked away with was basically giving them.
Peter: Their money back, plus interest.
Jon: Like a medium interest rate loan.
Peter: Yeah, that's it. That's it.
Jon: And then they just said, Look at the fine print. We're following the contract. See you later.
Peter: Yeah. Yeah. And look like that happened. I saw it. I said it happens in convertible notes, but it happens even more in safes, because at least in convertible notes, it's a little more common to put in like, a pseudo liquidation preference, you know, where you're like, Well, if the company gets acquired before this converts and like we get a2x on our investment right off the bat, right?
Peter: And sometimes you can put that in the safes, but it doesn't happen very often again, because you want to keep these things relatively streamlined and simple. And so far. So I don't know. I think I think that's an issue.
Jon: So safes aren't safe is what you're saying for investors?
Peter: They're not they're not as safe.
Jon: Sounds like an interest free loan. Let's do.
Peter: It. Yeah, exactly. Sounds like an interest free loan.
Jon: So money, why transfer checks aren't aren't things. And in 2023.
Peter: so, I don't know, like, I used to kind of think, safes are interesting, they're household or cheap or whatever. I'll tell you the other problem. I have a safes and this is something I've been thinking a lot about from the investor perspective is that it's easier to not have a lead investor if you have a safe car and I think what's happening right now is that there were a lot of companies over the last few years that raised these like party rounds with a bunch of safes.
Peter: No lead investor, nobody's on the board, for example. So like, this is just like a big issue, right? It's like the board seats. It's like, Hey, you're saying that a safe is equity, right? I mean, that's that's what they say. It's like it's it's equity. It's not that it's equity, right? But it's like this like pseudo equity that hasn't really become equity yet.
Peter: And because it's not equity yet, you don't have a vote on the board, you don't have a vote on how the company is directed. And founders may look at that and be like, that's fantastic, right? Like I've been able to do like take a bunch of money and and basically diffuse any sort of voting rights associated with that money that I've raised.
Peter: But here's the problem. A bunch of these companies that did these party rounds are now in a tough spot because they need more money and they don't have an investor that's like that's the lead that set the terms that wrote the biggest check that took the board seat. That's like guiding them like and ensuring and like pushing confidence into the company by putting up more money and all of the things, right.
Peter: Like and because they don't have that, they're in a tough spot because they need to raise more money and they don't have a lead to like corral the troops in and get a deal done. And certainly that still happens even when you do have a lead. But like, man, these party rules are tough, right? Because nobody's like standing up to take responsibility.
Peter: And when you've diffused all of the responsibility so much, ultimately I think a lot of investors look at and they're like, you know what? This was a relatively small investment for me. I'm out. I'm done right. Like, I'm not going to protect my prior investment. And then when that happens, you're toast as a company. Because if your insiders aren't participating, especially like institutional investors, like good night, like, good luck trying to raise, you know, from new investors because like, if there's not those investors who know way more about the company than I do that have been up for a long time, they're not doing it well, There's no way I'm touching it because I don't
Peter: know what I don't know here.
Jon: What percentage of investors are actually doubling down are using the pro rata rights today? Just in general? In general, not just like a ten year average.
Peter: Like I think it's been increasing. So what you had in the early days when I started in venture, people would start they get their pro rata rights, they'd sign on for a round or two until like the rounds got so big that they couldn't participate anymore. So and then they'd also get pushback because they, you know, this other firm is coming in.
Peter: They want a certain amount of ownership in the company. And so they would ask for prior investors to waive their pro-rata rights. But then what happened is funds like Foundry Group and others were like, Well, this is silly. We own these pro-rata rights. It doesn't make sense for us to keep wrapping in our core fund because like the return profile is not good enough to invest at the growth stage.
Peter: If if your fund is really a series, a fund. So we'll set up these like expansion or growth funds or pro rata funds or it's funds, you know, like whatever they call them. Right. And we'll raise that as a secondary vehicle to continue to participate in our pro rata because those pro-rata rights ended up being like super valuable.
Jon: Most valuable thing as an early stage investors, the pro rata rights.
Peter: I mean yeah, but I don't think it was always seen that way.
Jon: But what the current the current thought is.
Peter: Yes yes right. Because the game of venture is there's only going to be a handful of companies that matter. You want to be in at least one of those companies and then you want to put as much money into that company over time as you can. And pro rata rights give you that right and ability to keep putting money in.
Peter: So yeah, now that they've become like investors, more and more and more are taking advantage of their pro-rata rights. That said, in this current environment.
Jon: They're not or they're doing well.
Peter: They are, but for different reasons. It's more like if you don't participate at your pro rata, we're going to like wipe off the board, you know, with pay to play provisions and other things or what you'll have as VCs will be like, okay, I will participate at my pro router level, but that's it. I'm not you know, I want to be supportive, but I'm not really doubling down here.
Peter: Just, you know, it's an interesting dynamic.
Jon: So what's the current trend? Still continue with safes? I mean, that's a wiki. Does are they going are people going to price rounds?
Peter: Like, I'll tell you, like going through the current environment.
Jon: What is what I see currently do the same.
Peter: I am less excited about safes than I used to be.
Jon: Okay. Why should it that why currently as of the last the prior last class that give you a 150,000 value at 7%. So that would technically be a price round, but.
Peter: They do it through a safe or zero price.
Jon: Round. The second round will be three and 50 K, and then that would be on a safe.
Peter: Yeah. So they do a priced round to lock in value Asian and all these things I just talked about. Right. That are negatives and then like okay and then we'll give you more money in the safe because we're less concerned about that than we are. Like making sure that this thing has a set price, that we are owners, we have rights, right?
Peter: All those things. So look, I think if you're an angel investor, you are a seed fund. I would be thinking real hard about whether or not I do says because, I mean, look, even Y Combinator, the creator of the safe and biggest proponent of the safe, they don't even like use the safe for first rounds. Are you doing.
Peter: I mean, we're looking at companies that are raising sales, but typically we do price rounds.
Jon: It's probably less common for VCs, More common for angels, right?
Peter: Mark It Well, I mean, it depends on how you define VCs, right? Pre-seed Seed. A lot of them are still doing safes. There are a lot of companies that are doing bridge rounds that are safes, right where they're like, I don't want to do a price round right now because my valuation would be really low, but I need a little bit more money to get to the next milestone.
Peter: So we'll do a safe. Yeah. So you are seeing some of those. And in those cases, like I've seen safes with like pretty high discount rates, I've seen safes with very high warrant coverage included. That kind of gets you there, Right. So you're like, okay, well, we're going to do the safe. It's going to be like 20% discount with whatever cap.
Peter: But then we're also going to kick in 100% warrant coverage. And when you do that, you're effectively lowering the valuation, right? Like, if I invest in a company at $100 million valuation and I have 100% warrant coverage, I'm I'm effectively getting in at like $50 million valuation, right? So and so that's how pending warrants could could play a role, right?
Jon: Good to know. So if I. Let's break it up from two perspectives. Let's say as an investor, you don't like them, but if, like your stepbrother was raising, would you tell and he had a choice. We are sorry. Let me see. Step brother, stepsister, whatever. Yeah. Which way would you push them to say for price round?
Peter: If it's their very first round. I don't know. Like, here's the thing. It always depends, because fundraising is really hard, right? Even the best of times, it's.
Jon: Hard to say. They get the choice.
Peter: And so if it's if it's their choice, like I would say, like all things being equal, you should bring in a good, reputable venture fund that's going to lead year round and ideally price it.
Jon: And but that'd be for series A.
Peter: No, it could be. Could be PRE-SEED.
Jon: Okay. Not Got it. Do your price round as your general rule.
Jon: Because for me it's always looked at saves. The biggest risk is outside of like not knowing how much of the companies are owned by who. Yeah. That's always, you know, you can always figure that out with some, you know, some elbow grease.
Peter: Kind of sorta. No, not really. You don't know until the valuation set onto.
Jon: The valuation set. Right. But still.
Peter: Right. It could be that you set the valuation and you realize like, holy crap, I just got wiped out of the company.
Jon: All right, don't raise.
Peter: And then you go out of business and you get wiped out anyways.
Jon: Yeah. So there you go. All right, guys. Well, thanks for watching the Venture Capital podcast. Go to venture capital dot com. We were like, go to YouTube, the comments. We want to hear what you guys think. So we'll see you guys on the next episode.
