There are a few common ways to raise money for a startup: Sell a chunk of equity, and quite possibly give up some management control. Or take out a loan or other debt, much of which you could be stuck repaying even if your startup fails.
Vinayak Ranade, profiled in a story in The Wall Street Journal on Thursday, becomes one of the few founders to succeed with a third tactic: Collect money for investors in exchange for equity... someday.
To accomplish this, and to raise his $500,000-seed round, Ranade, the founder of Boston-based startup Drafted, used a financing tool called a simple agreement for future equity.
The Journal says the simple agreement for future equity was developed in December 2013 by Carolynn Levy, an attorney for accelerator Y Combinator. Since then, Levy says "most of" the 274 Y Combinator alumni companies have used the agreement, also referred to as a SAFE.
The bare-bones nature of the SAFE and its somewhat surprising lack of investor protections make it emblematic of an environment in which leverage has increasingly swung toward promising "hot" entrepreneurs and away from the investors looking to fund them. Investors in a SAFE get warrants that entitle them to shares in the company if and when it next raises money, if it gets acquired, or if it has an initial public offering. If the company fails or goes bankrupt, the investors don't get anything.
It makes sense that this financing strategy could first emerge at Y Combinator, because that accelerator's graduates often find themselves the subject of intense interest after their demo days. It's also not much of a stretch for an investor to believe that their favorite Y Combinator company will raise more money or become acquired, allowing their warrants to convert into shares.
The lack of investor protections makes a SAFE a tougher sell for companies that don't come with the Y Combinator seal of approval. But there are other substantial reasons for founders to give it a shot. First is the "simple" part of the simple agreement. The document can be as short as five pages. Other options are substantially more complicated, and as Ranade put it in the Journal: "No matter how much I learned about convertible notes, I would never know as much about them as a seasoned investor."
That's why you hire lawyers, you might say. But the SAFE's other advantage is quite possibly the most compelling: No valuation is assigned when a SAFE deal is signed. Given the shot-in-the-dark nature of assigning a valuation to a startup, the SAFE gives founders a chance to prove themselves before a valuation is assigned to their company.
While non-Y Combinator entrepreneurs who raise money via a SAFE may be few and far between, it's not too much to expect that a modified SAFE could become more popular for in-demand companies. The costs of building a tech company continues to fall, allowing founders to go farther on less money. The emergence a few years ago of blogs such as Venture Hacks provide a crash-course on venture capital and term sheets. And serial venture-backed entrepreneurs have become increasingly willing and available to mentor up-and-comers. The result: Angels and venture capitalists increasingly willing to abide by entrepreneurs' terms.