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Nov. 23, 2020

How do SAFEs work? By Phil Nadel

How do SAFEs work? By Phil Nadel

Phil Nadel, Founder and Managing Director at Forefront Venture Partners (formerly Barbara Corcoran Venture Partners), talks about the major instrument used for raising money - SAFEs or SAFE notes. We talked about the major misunderstandings about this instrument, who should use it and when is it time to price your round instead of using a SAFE note.

Phil's LinkedIn: https://www.linkedin.com/in/philnadel/

Forefront Venture Partners: https://www.forefrontvp.com/

Forefront Venture Partners on AngelList: https://angel.co/company/forefront-venture-partners

Fill out this form to get connected to investors and mentors: https://form.typeform.com/to/vT8gVQDG


And today is a guest speaker, we have feel knee Dale, founder and managing director ad.

For front Venture Partners, and today we'll talk about saves the most common, uh, instrument that founders are using to raise funding for their Serbs, but not everyone understands it. And there are many details that are not very clear.

So, today, we'll talk about that, how to use that instrument, who actually should use it. And what are some other options for fundraising so feel, let's kick it off by you giving us some background on yourself and on forefront Venture Partners.

Sure happy to thanks for having me on the show. So I've been in the venture capital space investing for many years. Now.

You know, I was a serial entrepreneur promoted in my career. So started and sold a bunch of companies.

And after doing that several friends and family members had asked me to advise them on their start ups, or invest in their startups, which I did.

And so that's what got me into venture capital and angel investing and then it grew into a full time occupation and a full time venture.

And it's something I've been doing now full time for probably about 15 years and about 7 or 8 years ago when AngelList introduced the syndicate feature.

That's when a forefront Venture Partners became a syndicate and start sharing our deal flow. And the deals we invest in, we have our syndicate investors.

That's pretty interesting. So we'll touch on to syndicate maybe a little bit later on closer to the end of the episode and talk a little bit more about what forefront Venture Partners investing.

So, let's start with the seats there, consider to be the standard tool for every single, early fundraising but.

How should founders come up with the evaluation? That's the 1st question. I mean, validation cap because there is not actual validation there, but there is a evaluation cap. So, how should founders come up with that?

1st, I want to just sort of push back a little bit and say.

That, you know, not every company early stage company is raising money using a safe.

Some will do an equity or priced round, but also a lot of companies just use.

A standard plain, vanilla convertible note agreement that's not a safe.

And then there are also alternatives to safe, which 1 is called a kiss.

So, there are other alternatives that companies are raising on, but safe safe notes are very popular as as you indicated. And so to answer your question.

Uh, 1st, I think it's really, really important.

To offer both evaluation cap and a discount. So sometimes we see companies that will have a discount.

But no cap or a cap in no discount or sometimes neither.

And both, uh, the only option in my mind that really makes sense is offering both evaluation cap and the discount.

So the idea, the basic idea is that early stage investors.

Shouldn't be rewarded for the risk that they're taking at this very early stage later. Stage investors have less risk and should should get different terms than the early stage investors.

So, in order to properly.
Sort of take that into account.

The best thing to do is to have a evaluation cap and a discount. So when you raise an equity round a price round.

Of, depending on where the valuation of that round is. The investors early on who invested in a safe.

Will either be have a discount off of the valuation, or they'll be capped at the valuation cap, but more specifically on the valuation cap.

There's a lot of confusion out there in the market with early stage startups about where to set that valuation cap and what it means.

And a lot of times companies.

Believe that the valuation cap should be.

The equivalent to the valuation that they're anticipating getting.

In their price round and.

In my mind, that is completely wrong. Ahead.

I don't think that's the right approach. I think entrepreneurs founders need to be realistic about what their current value is.

And set the valuation cap.

At something close to what they believe the current fair evaluation is now, as we all know.

Valuation is subjective.

It's in it in the eye of the of the beholder so to speak.

So that's a negotiable thing, but founders shouldn't be set on the valuation cap being what the next round will be. It's got to reflect the reality today.

Sense absolutely. Yes. And.

Yes, speaking of depicting the reality of today, let's talk about the mistakes, uh, what are and also we'll discuss the, uh, you know, coming up with the discounts for the seats later on.

But 1st, let's talk about the mistakes that you see, founders making while raising through safes. What do you think are the top? I know.

3 mistakes that you see, you know, I sort of alluded to it before, but. You know, the, the 1st thing is, is sort of like not to not to.

Consider the the risk that the early stage investors are taking to invest so early and what, I mean, by that is specifically not offering both a cap and a discount. I think that's a mistake.

And I think it's unfair to the investors. So that's 1, level of mistake is sort of using the wrong structure. Of of a safe note and and the other is.

In my view, setting the evaluation cap too high. I just think that there's a, there's a propensity in the market for founders to do that.

And I think they need to be realistic and send it at, you know, what.

Roughly they believe that the true current evaluation will be. So I think those are mistakes. I also think like, more generally.

You know, companies often fall into the trap of continuing to raise on an ongoing basis with safes or other convertible instruments. And I think it's smart.

Uh, you know, to to not defer too long, not to wait too long to do a price ground.

So, it's fine to do 1 round of a safe maybe even a 2nd round, but I've seen companies do 3, 4, 5, rounds of convertible notes or safes before raising a price round.

And then there's a lot of overhang.
And a lot of conversion that occurs into the price round. Will that will turn off some.
Uh, investor might otherwise participate.
In the price round so I think you have to be careful with that.

So question about the price round here why is that a problem? So, for me, personally, I don't really care if the round is priced or not. But how do you think that affects other investors in terms of why wouldn't endoser participate in a safe round? If.

He or she believes it's still a good company too. What's what's the data here?

If because the company has raised a lot of money on say, unsafes previously, and it all converts into the price round that's going to push up the post money valuation of that round considerably and maybe make it attractive.

Now, to your point, if it's still attractive to you, then great.

Um, then no problem, but it just, it makes it more difficult to price that round and make and make it work for everyone.

Right, yeah, that makes sense. So, let's go back a little bit to discussing the valuation cups and discount specifically discounts. So.

How important is the discount for investor you mentioned that, you know, if you, if the founder does

not include the validation cap or discount, that is bad, but.

What happens if discount is not really standard so I know that the center discount at early rounds is like, 23% but what if is, let's say, 10%. How how bad is that?

Well, 10% in my experience is not competitive. 20% is sort of the norm.

Um, and 225 and 30 we see also, but 20 is kind of typical. Mm. Hmm. And it's very important. It's very important to have that discount. Let's use an example.

Um, and say that that, uh, you know, a company.

Does it save with a, let's say a 10M dollar valuation cap.

And the early stage investors come in.

And the company does, okay, it's not doing great. It's doing okay. And they go out and they raise a price ground that's with evaluation of 10M dollars.

Okay, so the company has made progress.

They get a valuation of 10M dollars and those early stage investors.

An evaluation cap of 10M no discount.

They're going to be investing at the exact same terms.

As the later investors, which is inherently unfair, because the early investors have taken more risk.

But with a, with a discount in, in the example I gave if there were 20% discount.

The early investors on the safe would only be investing or be converting at an 8M dollar valuation not the 10M. So it really you're making sure that you're covering.

All scenarios and being fair to the early stage investors by having both the cap and.

Got it, so let's talk a little bit more about, you know, going off the standard path of raising receives and.

Well, let's pretend that you see a founder who is raising the preceed round at 2M cap and 30% discount. That's like, slightly that's.

Heavily below the standards. What what doesn't raise any red flags for you? Or is it like normal for you?

So, basically, in which cases should the founder actually drop their evaluations and increase their discounts.

Know, where you set the valuation cap in the discount it.
Very subjective, but it depends on a number of factors.
How much progress have you made? Is it Pre revenue or post revenue for example.

Do you have proprietary technology? Do you have, like, something that like a patent or something else? That's truly proprietary that will help you build a defensible mode.

How much business have you done? What your growth rate been? If, if you're doing revenue generating revenue? So.

It's like, what stage within that early stage framework? What stage are.

And then it frankly, it comes down to a negotiation between the investor and the company. So I don't see it.

Necessarily as a red flag, if a company. Uh,

has a low evaluation cap and high discount sometimes founders just don't know what the market is and they'll price it and they'll,

they'll put a cap in a discount without really knowing what the market is and and you can't blame them.

They don't. They're not in the market all the time.

And so they'll price it there. Um, and sometimes they'll price too high so.

It happens, I mean, it's best before you price around to try to get a sense.

Avoid similar companies similar stages.

I have gotten their investment done, right?

Um, and that's the best thing to do if you can, and sometimes if, you know, if, you know, are always stage investors or, you know, venture capital firm, they'll give you that feedback.

Other times you can sort of read about it online or in current space or whatever, but you can get that information to give you some guidelines. And the rest of it is just based on your.

The company's progress to date and, uh, and then what what they have that's proprietary.

And then in negotiation, that's that's what it comes down to really.

That's right so here, let's talk a little bit more about syndicates so you mentioned.

You know, for fraud, Venture Partners is a syndicate. So now let's talk about how syndicate mile works. So.

Let's start with the basic what is a syndicate? Sure. So.
It's a group of accredited investors.
In in my case through the AngelList platform.
Who are interested in investing in early stage companies and what we do for them is we share. Our deals that we're investing in, so we do all the deal sourcing.

We find the deals, we do a ton of due diligence. We negotiate the deal the event, the, the valuation.

We get the legal paperwork done and then we present the deal. We share those deals with the investors. They have no obligation to invest at all. They can choose to invest or not.

And if they do invest, they invest with us on the same exact terms.

That we're investing in, and there are no fees that are charged up front by us or angel list, but they do pay.

What's called the carried interest? So if they make a profit.

On the on the investment, ultimately, like, if the company is sold, or it goes public, if they make a profit, then part of that.

Profit is shared with us and AngelList so in short.

It's a way for early stage investors.

To get excellent curated.

Deal flow that's been a very that's been had a lot of due diligence done and they have the option to opt in or opt out.

And a lot of these folks can invest as good as a few 1000 dollars, which they wouldn't be able to do on their own with any of these companies. They wouldn't have access to the deals to begin with. But even if they did, they couldn't invest 5000 dollars.

The company wouldn't.

Wouldn't do that, so this gives them access and then I would say, finally there are lots of opportunities.

For our syndicate investors, our members to.
Help our portfolio companies to provide that assistance.

To the companies we invest in, and that's a big reason why a lot of them invest is because they enjoy helping entrepreneurs and founders grow their, their companies and we, we offer a lot of.

Opportunities for that. So that's a little bit about sort of how the syndicate model works. I guess I would say also that.

You know, it's important to note that all of the investors, uh, go into 1 entity. So they all their investments were all pooled into 1 entity.

And we created entity that then is the investor in the company that we're funding.

So, for me, the model sounds very much similar to an angel investor. I mean, angel group. So what's in your eyes? What's the major difference between the angel group and the same.


there are certainly a lot of similarities that I would say that the difference is that mostly with a syndication model,

like ours,
we're doing the more of the curation and due diligence and only sharing the deals that we're investing

in a lot of angel groups will share more deals and

and leave some or all of the due diligence up to the members.

And also, like, most angel groups have committees that will do due diligence themselves.

Uh, we, we don't operate that way. Syndicates are run by syndicate lead. In our case, it's forefront Venture Partners, and we do all the work, and we only make the best deals available, but all the.

All that you're done already it's presented to our syndicate members, so.

That I think that's the major difference. And sometimes I've seen angel groups where their investments go in individually.

Uh, into the company, and they have to invest a larger amount, you know, maybe it's a 50000 dollar minimum or something.

I want a syndicate, as I said earlier, you can invest much smaller amounts. So I think that sometimes is another, uh, difference as well.

That's really clear difference and like, the differentiation there so.

Well, let's talk about these startups now from the start founder perspective and specifically how to understand if your companies actually can be fundable basically. So, every single investor says, you know, 1st of all solve a real problem.

And question is how should founder understand that? The problem was real, so, what kind of testing should they go through? Is should they try to collect some feedback through.

Got the word now. Well, I mean, it's the best way to know if you're solving the real problem.

Is if you have the problem, right? If a founder had actually experienced the problem.

Themselves in their previous previous company or whatever, or even in their personal life.

Then they, the problem is they know that there's a real problem and they, they may not know the size of the market. They may not other.

Or companies are experiencing that same problem, but.

They know that there's a problem and they want to set out to solve it and they can't find.

Let's say an existing solution in the market that addresses that problem adequately. So they may.

Uh, as a next step, talk to some other.

Individuals or companies who they think may be experiencing the same problem and talk to them about it and see if in fact they are, or if they have a solution for it. So, at 1st.

It's about asking a lot of questions talking to a lot of people in the market.

Asking questions, understanding the problems they face and how they address those problems. Um, what are they doing today to solve the problem if anything and.

And is it something that they would pay for? So.
After having maybe experienced the problem, or observe the problem for themselves.

They then start expanding the net a little bit and talking to other people who may have that same problem. And then when it comes down to.

Is just doing a lot of asking questions and listening.

Listening to customers, listening to potential customers and finding out why they're buying why they're not buying.

And constantly changing and integrating your product.

To best address, the customer's needs, so it's very, very unusual.

To the 1st, version of the product.

To perfectly nail the product market fit and be that perfect solution.

Much more common is that the product changes and evolves.

Over time in response to customer needs and feedback, and you can only get that.

Feedback if you listen and observe very closely and ask good questions.

And so that's the key thing is.

Uh, the product is not going to start out perfect. A lot of people, uh, go to market within an MVP and, you know, you get something in the market and then you learn and adjust.

And constantly do that and stay in touch with your market and your customers.

And and then your product will be much more valuable to them. And that's the way that you sort of, make sure that you're constantly addressing.

The problem in the market, or that's very valuable and I'll make sure to mention this revenue is still better than feedback revenue sort of feedback itself.

So make sure to try to get people to pay you for what you're doing. That's just the best validation for an investor. So, let's talk about your own thoughts on this process specifically about the projections.

Invest projections of the founders made for investors. So you wrote an article called financial projections are never accurate.

Why prepare them personally love the title by the way so why do you think founders should actually take their time to make their projections? Because pretty much never the, or.

True. So why should they take time? That's that's a great question.

Yeah, yep and a lot of founders probably asked that question. That's why I wrote the article. But the answer is simple from an investor.

Perspective we know that the projections are not going to be accurate. But what I'm trying to understand.
Is how the founders are thinking.
I'm trying to get inside their heads a little bit.

To understand what assumptions they're making about the business and how it grows. Are those assumptions realistic.
Can they extrapolate.
The results to date, or the assumptions.

At scale, so I look for detailed financial projections that show how they come up with. Their their projections, so if you are projecting.
X amount of revenue next month.
Or in or in, let's say 12 months.

What is that based on? Is that just a guess?

Are you just saying, well, that's what I think we'll do, or? Well, I project we'll grow 10% per month.

That's plus not a good answer that doesn't.

Then then I would say, why do why you project 10% a month or why did you project that individual number? How did you get to that? What I want to see.

Is that there are assumptions that lead that revenue number as an example are realistic.
Uh, so, for example, in in a B, to C model.
Where, you know, the company sound directly to consumers.
How are they marketing it? What? Response? Rates and conversion rates are they assuming. What price point and churn rate are they assuming.

Are any of that based on their historical results or are they based on. Comparables in the market historical results.
How are those numbers derived in a B to B situation? It's similar. You know, how many sales reps are you going to hire?

How much is it? We're going to cost you what's your conversion rate?

You know, how much are you charging and what is that and what's your churn and what's the lifetime value? All of these things have to be rooted in some realistic assumptions that drive the business.

Does does the founder making the projections? Understand what drives the business. It's, you know, it's sales, it's marketing. What is it that drives that business.

And do they understand the the realistic numbers that go into that? So, again, it what we're looking for, in short.

In financial projections is to get inside the founder's heads and to understand the way that they are

thinking about this company, the way that they.
Are looking at what drives the company's growth and success what metrics do they need to hit. In order to achieve those revenue and even numbers. Does that make sense?

Absolutely, that's actually a really good reason to make financial projections. Very much reminds me off, you know, drafting the business plan for a startup. That's eyes preceded stage. Never really gets accomplished. Helps you navigate the company.


On this, you know, very explanatory notes we're moving on to a last question of today's episode, which is a call to action. So Phil, what's the 1 thing you want to learn to do? As soon as the episode is over?

You know, it sort of depends what their, what their plan is, but we're always welcoming new investors into our syndicate, which they can find on AngelList.

Uh, or go to our website forefront V. P. dot com if they're a startup founder.

Um, and their post revenue, I'd be happy to look at their deck or your their pitch. So if they're post revenue, we only invest in post revenue companies.

Post revenue can contact us either on our website, or they can contact me on LinkedIn directly.

Uh, and share their, their deck, um, and so, you know, get in touch and let me know if you're interested in being, uh, an investor or if you're looking for an investment.

And, uh, and we'll address it appropriately. So, LinkedIn or website forefront com or directly on AngelList just search for forefront Venture Partners. Perfect, great. I'll make sure to leave all the links.

You just mentioned in description the episodes I'll also make sure to leave the link to your article. And so I was curious to read more about drops into financial projections and how to do that. Definitely take a look at that link and.

Yeah, my is going to go to the description of the app as I would take a look at the links, go through them, find something useful for yourself and.

Try to January some sales and it's usually try to have a good date.