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I was considering my first angel investment, so I called a longtime friend for advice.

“So you want to throw some money into the wind?”

“Yeah, man… 10 years in the making,” I replied.

It had been ten or so years since I was sitting in my bedroom listening to This Week in Venture Capital (before it was TWIST), dreaming of the day I’d make my first startup bet.

I felt like the startup had product-market fit, the founding team saw the world the same way I did, and they operated in a space I knew well.

What I didn’t know is if the terms of the deal were any good.

The startup at hand was raising $2m on a SAFE. They had three prior SAFE rounds and had yet to raise a priced round with an institutional investor. While it wasn’t described this way, this investment was a bridge round for a priced Series A round. This means the founders had yet to find a lead investor and needed more money to “bridge” themselves to a priced round.

To me, using a SAFE was no big deal. I admired Paul Graham and the YC crew. I had seen dozens of SAFEs during my time as a VC analyst. However, my friend and mentor, who I called, helped me to better understand the potential dangers SAFE investors incur. Since then, I’ve done quite a bit more research on the topic. Writing helps me think, so here are my findings.

A quick refresher on how a SAFE works

If you are new to SAFEs or you need a refresher I recommend checking out YC’s Kristy Nathoo’s helpful video explanation.

The potential drawbacks of investing on a SAFE

A SAFE is a simple agreement for future equity. The price of that equity is not yet determined. In order to decrease the amount founders and early-stage entrepreneurs are negotiating over, the SAFE generally lets the investor assume the terms received by the investors in the Series A round. However, institutional investors do not always play nice. Often if institutional investors have significant leverage over the founders, they can make requests that hurt the SAFE holders.

For example, they could require a specific number of shares created for an option pool, diluting the SAFE holders ownership.

The institutional investors leading the A round can mess with the liquidity preference in their favor when they have significant leverage.

The A round investors may require that SAFE holders lose their pro-rata rights in future rounds after the A round. Or they may require a certain minimum investment to hold pro rata rights. Generally, this amount is higher than most angels are comfortable re-investing.

There are countless more scenarios. The challenge here is when the founders are in trouble and really need money from the institutional investor leading the A round, the SAFE holders are in trouble too. Participating in priced rounds is significantly more advantages.

Pro-rata rights: A $10,000 bet is really a $100,000 bet.

The lead investor makes all the rules. The more lead investors fighting over a deal, the better the terms for the founder and the early stage angels. The less competitive the deal, the more aggressive the lead investor can get with the demands.

SAFE investors should ask founders for pro-rata rights. Pro rata rights ensure SAFE investors can purchase future share issuances to maintain the percentage ownership currently held.

For example, I may own 1% of the company today. If future shares are issued, I will own less than 1%. Pro-rata rights, which vary across deals, would give me the ability to purchase shares of the future issuance to maintain my 1% mark.

In order to “protect” an investment, many investors allocate funds to defend their position and purchase newly issued shares to maintain certain percentage ownership. Investing in the company one time and getting diluted down after each consecutive round is a losing strategy. Instead, investors with conviction in the company should ask for “pro-rata” rights. This gives the SAFE investor the ability to purchase shares in future rounds.

So when you are looking at the next round, don’t think you are just making a $xx,xxx bet. In order to win, you are putting $xx,xxx down now with the understanding you will need to participate in future rounds to protect your position. A $10,000 bet today could very well turn into a $100,000 bet years later, so make sure you’re investing in projects and founders you really like!

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