Investing in startups can be risky, and it is important for investors to carefully consider the pros and cons of different investment instruments. Some pros and cons of investing in startups via equity (common stock) versus a SAFE (simple agreement for future equity) instrument are:
Pros of investing in equity:
- The potential for high returns: If the startup is successful, investors may be able to earn significant profits through the sale of their equity or through dividends or other distribution of profits. - Voting rights: Holders of common stock typically have voting rights in the company, which allows them to have a say in important decisions related to the company's direction and management.
Cons of investing in equity:
- High risk: Startups are high risk investments, and it is possible that the company may fail and investors may lose their entire investment. - Dilution: As the company raises additional rounds of funding, the ownership stake of earlier investors may be diluted.
Pros of investing via a SAFE instrument:
- Simplicity: SAFE instruments are simpler and faster to execute than traditional equity financing documents, which can save time and legal fees. - Flexibility: SAFE instruments can be customized to fit the specific needs of the company and the investor.
Cons of investing via a SAFE instrument:
- No ownership stake: SAFE instruments do not convey ownership in the company, so investors do not have voting rights or the potential for dividends or other profit distributions. - Potential for low returns: If the company is successful and subsequently issues equity to investors, holders of SAFE instruments may receive less favorable terms than later investors who invest via equity.
So what do you think @Brian Belley ? Was the ChatGPT response to your question (Describe the pros and cons of investing in startups via equity (e.g. Common Stock) vs. a SAFE instrument) a pass or fail response?
ChatGPT did a very decent job overall, but missed out on a few important pros/cons.
Another pro (which is a con for SAFEs) are potential tax benefits under Section 1202 Qualified Small Business Stock (QSBS) gains, as well as Section 1045 and Section 1244 for rollovers and losses. Those require that you held equity (along with many other requirements; please consult a tax advisor) - which some tax and securities attorneys may tell you is not satisfied by holding SAFEs or Convertible Notes (even though some SAFEs from Y-Combinator have a specific clause that says they should be treated as equity under Section 1202 - it's definitely an area with a lot of opinions!). Regardless of whether or not it qualifies for SAFEs, equity removes any doubt in terms of meeting that particular requirement for potential tax benefits.
Despite not being equity, during a liquidation event, many SAFEs will actually get paid out on par with Preferred Stock, senior any to Common Stock distributions. This can vary from SAFE to SAFE, so it's important to always check the specific deal terms.
Another con is that some SAFEs come with repurchase rights, which are very unfriendly to investors. They basically allow the issuer to repurchase the SAFEs from early investors, typically at the original face value or fair market value (FMV). However, how FMV is determined can be taken advantage of issuers who use timing (e.g. during the quick April 2020 downturn, prior to the immediate recovery and then some), and typically only companies that are doing very well will want to repurchase shares, so this can impose a cap on the upside potential of an investment, which goes against the asymmetric risk/reward profile that startup investors are often searching for.
A nuance that most investors do not appreciate (and ChatGPT may have missed) is that sometimes SAFE holders may have another hidden benefit of receiving less dilution during follow-on rounds. This is because their SAFE can be deferred from converting to equity under certain terms and circumstances; this means that, if it has a valuation cap and does convert further down the road, instead of getting diluted at each subsequent funding round along the way, SAFE investors won't start getting diluted until after they convert to equity. This comes with the flip-side of that coin, which is that by not converting to equity earlier, investors are potentially missing out on voting rights, dividends, and other benefits that being an equity holder conveys.
THIS is why I am so blessed to be surrounded by such brilliant people. @Brian Belley's response to the Chat bot that's all the rage was far beyond the state of the science. It required knowledge and nuance--right there on the fly.
Makes me appreciate that at the end of the day, even computers were programmed by people.
Cheers to humans! And big thanks to Brian. The CfPA is so fortunate to have numerous execs as smart and generous as Brian. If you're interested, check us out--always room for more talent on our team.