Jarod Angehr is a finance professional from Texas State University, a start-up consultant and mentor, and entrepreneurially-focused writer on venture capital, start-up growth strategies, and start-up financing. Jarod is also a Venture Associate with Austin-based global accelerator, Newchip. He contributes today’s guest post on an increasingly used form of early-stage funding for startups, SAFE notes.

If you’ve researched funding options for your startup, you’ve come across the SAFE note. It stands for Simple Agreement for Future Equity and is a relatively new form of security the Silicon Valley accelerator program Y Combinator created in 2013.

The SAFE note was designed to be a simpler alternative to convertible notes. Founders loved using convertible notes because they are not counted as debt and the investor does not take equity until the note converts. Investors tolerated convertible notes but found that they required a lot of negotiation with founders and could be lengthy and complicated.

SAFE notes have become a popular offering for founders because they’re usually five-page documents, making it easy for most founders to draft and require almost no negotiation. Because SAFEs are not debt notes they don’t accrue any interest and they have no maturity dates. If the company never decides to raise again, the SAFE will continue in perpetuity without ever converting.

Like most convertible equity notes, SAFEs grant investors the right to receive a certain number of shares in a future priced funding round. Since SAFE investors are investing earlier and taking more risk than Series A investors, the SAFE investors will pay for their shares at a lower price than the Series A investors.

The SAFE note’s drawbacks for both the investor and the founder, however, often go unnoticed.

While SAFEs are relatively new, most investors have become aware that founders have fewer binding responsibilities. SAFE notes are not an official debt instrument, so sophisticated investors know there is a chance they may never convert to equity. Another liability for investors is that repayment is not required.

Offering a SAFE note could also signal to an investor that you, as the issuer, may not be sure about the future of your company. As a founder, you may be able to collect small SAFE checks but once you seek larger investments, you’re going to have a hard time because venture fund managers understand how poorly SAFE notes perform.

Founders run the risk of overlooking dilution and ignoring capitalization table math when using multiple rounds of SAFE notes with different valuations. SAFEs have a multiplier effect on post-money valuation — a company’s estimated worth after outside financing is added. Venture capitalists (VCs) typically concentrate on a startup’s value pre-money. That translates into venture capitalists passing on investing in a company because the flood of SAFE notes that would convert upon the investment would consume too much equity.

When a startup has used numerous rounds of SAFE notes, it’s a solid bet that the SAFE note rounds more than likely occurred at a different valuation for each and were purchased by a slew of different investors. This results in a confusing mess of equity that will be given out at one time. VCs understand that their investment, being in the first priced round, will trigger all past SAFE notes to convert to equity with an instant company recapitalization as the result. With so much equity given out in different amounts, founders can find their own shares as well as everyone’s diluted.

This is a devastating problem for the company moving forward while trying to raise another round.

Along with dilution issues, SAFEs often have lower returns than other offerings. As equity is reduced in a price round, SAFE investors don’t get the return they were looking for even if the company becomes successful. This is because SAFEs don’t come with anti-dilution rights. When it comes time for a SAFE to convert, the ‘pie’ has been divided so many times that there is not enough left to yield the return the investor was anticipating when initially buying the SAFE.

A SAFE note also does not accrue interest. Investors typically will hold a SAFE note on average three years before it coverts (if it ever does), yet earn no interest on the note.

SAFE notes, created to give founders more funding options, are far from being a good investment for any educated investor. As it turns out, SAFEs also create issues for founders.

One major concern for founders is their equity in the company. SAFE notes are a great way to bridge the gap until your next round. The problem occurs when you use SAFEs to bridge the gap between the next SAFE note or if you use SAFEs to bridge every gap between rounds.

When SAFE notes are used improperly and build up over time, they create a cliff, and at the edge of this cliff is a colossal drop off in the owner’s equity. By the time a priced round occurs, the dilution is already set to unfold. Once the price round finishes, founders who don’t do the dilution math watch their ownership stake drop ten to twenty percent overnight. This can be devastating to founder motivation and to the future of the business.

Try Revenue Sharing Instead

If SAFE notes are undesirable for both issuers and founders, what is the better option for short or small rounds?

A 2018 Village Capital study of over 200 investors and asset managers found that 63  percent of investors chose revenue sharing as their most preferred alternative capital strategy.

A revenue-sharing agreement is a capital investment that is repaid with a percentage of revenue as the company generates it. Repayment occurs over a certain period of time and ends once the amount has been repaid. There are no hidden clauses in most revenue-sharing agreements which means that you, as an issuer know exactly what percentage of your revenue you must pay and for how long. You comply with the agreement without losing enormous portions of your ownership stake.

Unlike SAFEs, revenue sharing agreements are customizable, so they can be tailored to your needs. Finding funding as a pre-revenue company can be incredibly strenuous. Even a traditional equity offering will not get the job done as equity may not provide a return for investors for years. With a revenue share, the time an investor waits to see a return decreases exponentially, which could potentially make it easier for you to find investors.

Many funds are starting to pick up revenue shares as a primary investment vehicle. Novel Growth Partners currently has a $12 million fund that focuses on revenue shares with software as a service or SaaS startups. Indie.vc just completed the raise of their second fund of $30 million that uses a profit-sharing structure and receives disbursements based on the greater amount — revenue share or percentage of net income.

These are just a few examples, but more funds are adopting revenue sharing as an investment method.

Your early investors are going to be with you for some of the most transformative years of your company’s development. Getting the right investors on board is vital to realizing the growth and success you are seeking. The takeaway is to remember that not all investments that benefit investors help founders. While a revenue share can prevent you from reinvesting all revenue back into your startup, not giving away equity is a far better alternative.

If you are looking for quick financing between rounds or just to get to the next revenue stream, ask yourself: “What is the best offering that will attract the right investors and be beneficial for me?” While SAFE notes may be one answer, the gaining popularity and success of revenue-sharing agreements might be the solution to your financing problems.

Featured image is of a laptop on a glass desk showing financial projections. Photo by Carlos Muza on Unsplash.