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Carolynn Levy and Kirsty Nathoo - Startup Investor School Day 1
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Startup Investor School is a free, 4-day course designed to educate early stage investors interested in investing in startups. We'll cover the fundamentals of investing, from investing instruments to legal and accounting basics to evaluating startups and managing deal flow. Our hope is that more people, from a wide range of backgrounds will consider investing in startups and that those who do will be better at it. Learn more at https://investor.startupschool.org/
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Meet the Experts
In this segment, the speaker introduces Carolynn Levy and Kirsty Nathoo, two leading experts in startup investments. The discussion highlights their extensive experience with thousands of companies and sets the stage for understanding the fundamentals of startup investing, particularly focusing on the SAFE (Simple Agreement for Future Equity) instrument.
"all right this next session is actually one of my very favorites because there's so much mystery in the fundamentals of how you actually do a startup investment what it really means and how it works a..."
Understanding the SAFE
Carolynn Levy explains the SAFE, a crucial investment instrument designed for early-stage startups. She clarifies that the SAFE is not a loan or debt, emphasizing its simplicity and efficiency for both investors and startups. This segment lays the groundwork for understanding how the SAFE operates and its intended use in startup financing.
"Carolyn is the is the person who actually invented the safe she used to be attorney it it it will see me before coming here and Kirsty is the CFO of YC they to have have a couple of pithy quotes you c..."
When to Use the SAFE
In this segment, Carolynn discusses the appropriate scenarios for using the SAFE, particularly for very early-stage startups that have not yet raised a priced round. She highlights the advantages of using the SAFE for quick and efficient fundraising, especially when traditional financing methods may be too complex or costly.
"this presentation is about how to invest using Y Combinator's is my mic not on do people nine lights on just on low better better better better ok I think we're good ok so as I was saying this present..."
Key Features of the SAFE
Carolynn details the key features of the SAFE, including its structure and the two main terms that investors negotiate: the investment amount and the valuation cap. She emphasizes that the SAFE is a convertible security that allows investors to convert their investment into equity at a later date, making it a flexible option for early-stage investments.
"will be helpful it will be helpful okay um we drafted the safe for very early stage startups so that means that the company maybe hasn't written or definitely hasn't raised a priced round doesn't have..."
Types of SAFEs Explained
Carolynn introduces different types of SAFEs, including capped, discount, and uncapped SAFEs. She explains how each type functions and the implications for investors, particularly focusing on how the capped SAFE is the most commonly used version. This segment provides clarity on the various options available to investors when considering a SAFE.
"cheaply because neither the investors nor the company need to get legal counsel okay the safe is an acronym stands for simple agreement for future equity as I said before it is a convertible security ..."
Understanding Pro Rata Rights
In this segment, Carolynn discusses pro rata rights included in the SAFE, which allow investors to maintain their ownership percentage in future funding rounds. She explains the importance of these rights and how they work in conjunction with the SAFE, ensuring that early investors can continue to participate in the company's growth.
"are the only two things that you negotiate with the company it is just that simple after the intro paragraph there is a whole section that describes the conversion events which we will get into in a m..."
The Capped SAFE Explained
Carolynn elaborates on the capped SAFE, detailing how it sets a maximum valuation for conversion into equity. She clarifies common misconceptions about the cap and emphasizes its role in rewarding early investors for taking on higher risks. This segment is crucial for understanding the strategic advantages of using a capped SAFE.
"to buy shares of this Series B financing so that you can maintain your pro rata percentage okay so um what we are what I've been talking about is what we call the capped safe it's the one that has the..."
How SAFEs Convert
Kirsty Nathoo takes over to explain the conversion process of SAFEs into equity during a priced round. She outlines the steps involved, including the creation of an options pool and how the conversion affects share calculations. This segment is essential for investors to grasp the mechanics of how their investments translate into ownership.
"and then a third version is what we called the MF n safe MF n stands for Most Favoured Nation it's a it's a concept we borrowed from contract law and there is no target valuation in this safe but ther..."
Calculating Share Conversion
Kirsty dives into the mathematical aspects of how shares are calculated during the SAFE conversion process. She explains the importance of understanding the price per share and how it impacts the number of shares an investor receives. This segment provides practical insights into the financial implications of investing through a SAFE.
"rewarded for coming in at the earlier stage when in theory you're investing at a riskier stage it's it's the way to for you to get your rewards and your bonus and so ideally what you really should be ..."
Calculating Share Distribution
This segment explains the calculations involved in determining how many shares an investor receives based on their investment amount and the price per share. It highlights the importance of understanding capitalization and how it affects both SAFE holders and new investors during a priced round. The segment emphasizes the complexity of these calculations and the role of valuation caps.
"as we'll go over in a moment and so when the price round closes three things happen and in the documents they're all happening at the same time but in the calculations they actually go in order and yo..."
Example of SAFE Conversion
An illustrative example is provided to clarify how SAFEs convert into shares during a priced round. The scenario includes founders, their share distribution, and the impact of raising funds through SAFEs. The segment breaks down the calculations for share conversion and the resulting ownership percentages, making it easier for investors to grasp the implications of their investments.
"time will invest their money and buy their shares okay here comes the mass so it's a very high level for any investor the number of shares that an investor will receive is the investment amount divide..."
Understanding Cap Tables
This segment introduces the concept of cap tables, which outline the ownership structure of a startup. It explains how shares are distributed among founders, SAFE investors, and new investors, and highlights the differences between common and preferred shares. The discussion emphasizes the importance of cap tables in understanding ownership proportions and the effects of dilution.
"the company raises $800,000 on safes and they all have the same valuation cap they all have an eight million dollar cap then fast forward to November 2019 of an it can take that long maybe even longer..."
Impact of New Investments
In this segment, the focus is on how new investments during a priced round affect the capitalization and share distribution. It explains the calculations for determining the price per share and how the inclusion of converted SAFE shares alters the overall ownership structure. The segment provides insights into the dynamics of fundraising and investor returns.
"price is the valuation cap because the cap is less than the priced round divided by that capitalization to give a conversion price of seventy seven cents so the shares that the safe investor buys are ..."
Navigating Ownership Percentages
This segment discusses the challenges SAFE investors face in predicting their ownership percentages after a priced round. It highlights the variability in ownership based on the terms of the round and the amount of new money raised. The segment encourages investors to model different scenarios to better understand potential outcomes and ownership stakes.
"will buy two point eight seven million shares okay so bringing this all together this is a very simple cap table it's much prettier than cap tables normally look so for those of you that are not famil..."
What Happens in an Acquisition
This segment explores the outcomes for SAFE investors in various acquisition scenarios. It contrasts the favorable conditions of a successful acquisition with the less favorable outcomes of an aqua hire. The discussion emphasizes the importance of understanding the terms of the SAFE and the investor's options during these events.
"you can see that my maths did work our options pool is 10% of the total post-post money shares which is the total of these two numbers now safe investors have quite a hard time of it because at the ti..."
Dealing with Startup Failures
In this segment, the focus shifts to the unfortunate reality of startup failures and the dissolution process. It explains the hierarchy of repayment for creditors and how SAFE investors are positioned in these scenarios. The segment provides a sobering look at the risks involved in startup investing and the potential for loss.
"actually never happens so the reason why this 7% is not 9% is why it's less is because the safes have been diluted by the new money coming in and just as an example to just explain a little bit more i..."
When Nothing Happens
This segment discusses the scenario where a startup becomes self-sustaining and does not pursue further funding rounds. It highlights the implications for SAFE investors and the importance of understanding the startup's trajectory. The segment encourages investors to consider various outcomes and the long-term viability of their investments.
"so that you can see you can play around with the calculations and you can see how safes might convert in the future ok okay so suppose you've invested in a company and before it raises a price round s..."
Understanding Aqua Hires
In this segment, Carolynn Levy explains the concept of aqua hires, where acquiring companies focus on taking talent from startups rather than purchasing their assets. She discusses the implications for investors holding SAFEs, emphasizing the importance of understanding the financial outcomes in such scenarios.
"would happen in an IPO by the way so same same situation same result rather okay other end of the spectrum is the aqua hire and I don't know if this is a term that all of you in the room are familiar ..."
Navigating Startup Failures
Levy outlines the dissolution process for startups that fail, detailing how creditors, including SAFE holders, are prioritized for repayment. She highlights the harsh realities of investing in startups, where often there is little to no return for investors in failure situations.
"sometimes a company raises money from you and other angel investors and just can't make it work hopefully they try really hard but sometimes it just doesn't happen and they fail and when failure happe..."
What Happens When Nothing Happens
This segment discusses the scenario where a startup becomes self-sustaining but does not pursue further funding or acquisition. Levy explains why SAFEs do not typically address this situation and the implications for investors who may have inadvertently funded lifestyle companies.
"if nothing happens so this would be a situation where the company has raised angel and you know raised from angels and actually become self-sustaining you know profitable and they just putter along an..."
The Handshake Protocol
Levy introduces the handshake protocol, a method to avoid misunderstandings between investors and founders. She emphasizes the importance of clear communication and written agreements to ensure both parties are aligned before finalizing investments.
"company they've been I think our advice would be to go talk to the founders about it because hopefully you invested in really good people and they would want to do right by you and figure out how to m..."
Signing SAFEs and Using Clerke
In this segment, Levy explains the process of signing SAFEs, including the use of the Clerke platform for document management. She discusses the importance of reviewing details and ensuring accuracy before committing to an investment.
"about the process for actually signing the safe and then also for converting it into the shares so the first thing in this process is the handshake protocol and the reason why we created this is to he..."
Reviewing Conversion Documents
Levy stresses the need for investors to review conversion documents and cap tables carefully when SAFEs convert. She warns about the potential for errors and the importance of understanding ownership stakes post-conversion.
"slightly more detailed blog post about but those are there those are the key points most YC founders will use Clerke to send and sign safes and this is an online platform that uses the standard YC saf..."
The Importance of Quick Action
This segment highlights the necessity for investors to act quickly in the investment process. Levy discusses how delays can impact the investment opportunity and the importance of having funds readily available when committing to a startup.
"you receive a signature request through Clarkie or whatever other means you should check that the details in there are what you previously agreed to in addition you should check that the name and sign..."
Understanding Cap Tables
Levy elaborates on the significance of cap tables during the conversion of SAFEs. She advises investors to ensure they understand the calculations and terms, emphasizing the need for diligence in reviewing these documents.
"delay the process or that say that they want to invest and then say to the founders oh but hang on because I just need to close my fund or I'm just this companies nearly exited and I'm just waiting fo..."
Key Takeaways for Investors
In this concluding segment, Levy summarizes essential points for investors, including the use of SAFEs, understanding rights as a SAFE holder, and the importance of patience in the investment journey. She encourages investors to be supportive and tolerant of the challenges startups face.
"have much time to review these documents and to review the cap table you know that the founders will be focusing on the lead investor they'll be negotiating with the lead investor and they'll have set..."
Key Takeaways on SAFEs
Levy summarizes the complexities of SAFEs (Simple Agreements for Future Equity) and stresses the importance of understanding rights as a SAFE holder. She encourages patience and long-term commitment to the investment, highlighting that investing is a long game with ups and downs.
"founder as a chance okay so in conclusion we have covered quite a lot here and safes although on first glance look simple can get quite complex so if there's anything to take away from this these are ..."
Understanding Valuation Caps
In response to a question about ensuring full rewards as an investor, Levy explains the implications of valuation caps in SAFE agreements. She discusses the potential upside of early investments and the importance of exercising pro-rata rights to mitigate dilution.
"so the the question is how do you make sure that you are fully rewarded is that what you were saying okay so so and the vulnerability of the cap to the subsequent money so you know the numbers we're t..."
Navigating SAFE Agreements
Levy addresses concerns about how much money founders can raise on SAFEs and the implications of signing SAFEs with different valuation caps. She emphasizes the need for founders to be thoughtful about dilution and fair treatment of investors.
"question was directed towards the safe itself as potentially vulnerable and I don't see that I I think that that's a misunderstanding of the way convertibles convertible debt or a safe actually conver..."
Pro-Rata Rights and Investor Protection
Levy discusses the importance of pro-rata rights in SAFE agreements, especially during conversion rounds. She advises investors to assert their rights and ensure that founders honor contractual obligations, emphasizing the significance of reputation for both parties.
"so the question was who controls how much money the founders raised on safes and what do you do as an investor if you sign a safe with let's say an eight million dollar cap today and then the founder ..."
Investing as an LLC vs. Individual
Levy explores the tax implications of investing as an LLC versus as an individual. She explains that while LLCs are pass-through entities, individual investments may be simpler unless pooling funds from multiple investors.
"mentality going on in investing and so if if an 8 million cap works for other investors then you know the next investor is likely to take that as well maybe the situations where sometime further down ..."
Pro-Rata Rights in Conversion Rounds
Levy clarifies why pro-rata rights are not included in conversion rounds of SAFEs and discusses the evolving landscape of seed funding. She mentions that investors can negotiate side letters to secure pro-rata rights during conversion.
"we see this happen all the time oh did everyone hear that question ooh Oh for the low right okay so what happens when the lead investor in the state let's say you have a safe and it's converting into ..."
The Necessity of Private Placement Memorandums
Levy answers a question about the need for a private placement memorandum (PPM) when using SAFEs. She asserts that a PPM is not required, and discusses the global applicability of SAFEs, noting variations in different countries.
"so the question was should we consider investing as an LLC or as an individual for tax considerations and various other things well so if you're immersed in an LLC they're pass-through entities anyway..."
Understanding SAFE Validity Across Countries
This segment discusses the validity of SAFE (Simple Agreement for Future Equity) documents in different countries, highlighting that their acceptance can vary based on local regulations and investor qualifications. It emphasizes the importance of doing thorough research when investing internationally to ensure compliance with local laws.
"they don't necessarily work I know that we've heard some companies in India aren't able to use safe so I think it depends on the who the investor is they have to be on a certain list and also I think ..."
Trends in SAFE Conversions
Levy discusses the trend of SAFEs converting at different times than Series A rounds. She highlights the increasing sophistication of lead investors and the need for SAFEs to adapt to changing market conditions.
"so the question is sometimes this question has had safes that don't converse in the pre-money and how common is that well so first of all it's it's getting less and less common that the safes convert ..."
Educating Founders on Dilution
Carolynn Levy shares her experience in educating founders about dilution and SAFE conversions during fundraising. She stresses the importance of understanding these concepts and encourages founders to utilize available resources to model their cap tables effectively, which can help eliminate confusion.
"that that exact point is exactly what this gentleman was saying about pro rata because that is more of a trend that we're seeing that sort of argues for going ahead and having the safes also have a pr..."
Educating Founders on Investment Mechanics
Levy emphasizes the importance of educating founders about the intricacies of investment agreements. She shares her experience in guiding founders through the fundraising process, ensuring they understand the implications of their agreements.
"yeah yeah so so the point there was that that founders don't understand this either and that's absolutely right and you know again one of the things that I spend hours and hours with founders as they'..."
Negotiating SAFE Terms
Kirsty Nathoo explains the concept of the Most Favored Nation (MFN) clause in SAFEs and discusses the negotiation of target valuations and discount rates. She clarifies that while MFN clauses are not standard, they can be included if both parties agree, emphasizing the importance of fair negotiations.
"okay the question is is there case law around investor liability when you're investing as an individual rather than through a legal entity there is tons of case law regarding an stockholder non liabil..."
The Case for SAFEs Over Debt
Carolynn Levy argues for the advantages of SAFEs compared to debt in startup financing. She highlights how debt can jeopardize a startup's survival and explains that supporting founders often leads to better outcomes for investors, reinforcing the philosophy of being on the side of the founders.
"so it's possible you could just cut and paste that paragraph right into a capped or a discount safe if you want to I wouldn't I would counsel founders that that's probably not the right way to go but ..."
Looking Ahead to Tomorrow's Sessions
In this closing segment, Carolynn Levy previews the next day's sessions at Startup Investor School, including discussions on founder meetings and insights from experienced investors like Paul Buchheit and Michael Seibel. She expresses gratitude to attendees and encourages continued learning.
"we're done today tomorrow we are going to be kicked off by Dalton Caldwell talking a lot about founder meetings which is going to be a great session I think and then after that we have two amazing pre..."