What are the hidden risks of using SAFE notes for early-stage startup fundraising?

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Wow, great question. With a long answer. Plus the seed for a future substack post. And very very timely.

I am actually an investor - using a SAFE note - in a comany that just ran into what I suspect is the thing that these angels hate about SAFE notes. And it resulted from the fact that founders sometimes spend too much time debating which investment paperwork to use, and not enough time understanding what the instrument actually does to their ownership.

I’ve seen the pendulum swing pretty dramatically on this. Convertible notes used to be the standard way to avoid having to price a very early-stage company. SAFEs came along and removed a bunch of the friction: no interest, no maturity date, fewer documents, less negotiation, lower legal costs. For a founder trying to raise a relatively small amount of money quickly, that’s genuinely useful.

The problem I have with SAFEs isn’t really the SAFE itself. It’s that they make it incredibly easy to postpone understanding dilution.

You raise $250K on one SAFE. Then another $300K. Then somebody offers you $500K but wants a different cap. Then there’s another SAFE with a side letter or an MFN agreement. Each individual decision feels relatively painless because nobody is sitting around negotiating exactly what percentage of the company they’re buying.

Then you get to your priced round.

Suddenly all those promises convert into actual shares, the new investor wants 20%, you need to create or refresh an employee option pool, and the founder discovers that they own considerably less of the company than they thought they did.

That’s not a SAFE problem. That’s a founder not paying attention to the numbers problem.

Convertible notes have their own disadvantages too. Debt has a maturity date. There’s interest. If you haven’t raised the next round when the note comes due, you have an uncomfortable conversation. In most venture-backed startups nobody actually expects the company to repay that money like a bank loan, but the obligation exists.

So I wouldn’t tell a founder, “Never use SAFEs.” In fact, my advice is probably the opposite. For most very early rounds, I think they’re the best instrument. Just make sure that as they add up, you're keeping track of what your cap table will look like once all those SAFEs convert, after the option pool gets increased, and after the next investor takes their expected ownership.

This isn't neccessarily you're problem now , but eventually you'll want to understand what happens under multiple differnt scenarios: What happens if the next round is at $5 million? $10 million? $20 million? What happens if you raise another $750K in SAFEs before getting there?

The more subtle lesson here is that sometimes friction can be useful. SAFEs deliberately remove a lot of that friction which allows you to make decisions without recognizing their cumulative consequences.

So when an investor says, “We use SAFEs, but we hate them,” I suspect some of what they're reacting to is arriving at a financing and finding a cap table littered with SAFEs issued at different caps and on different terms. And in the specific case I mentioned just happened to me, it was very difficult for them to raise a round - despite having a successful business - because there was so much of a SAFE overhang, that there wasn't room for the option pool, and founder equity, and a new investor, and all of the SAFE conversions. Something had to give - and guess who got crammed down?

So ... to get to the point ... I would still do a SAFE. I would just make sure I was also asking:
- how much money do I actually need?
- where will that take me
- will reaching that milestone make it easier - or harder - to raise additoinal money.

Those ... rather than which type of investment paperwork to use ... are the more important questions.