Describe the pros and cons of investing in startups via equity (e.g. Common Stock) vs. a SAFE instrument.

So what do you think @Brian Belley ? Was the ChatGPT response to your question (Describe the pros and cons of investing in startups via equity (e.g. Common Stock) vs. a SAFE instrument) a pass or fail response?

ChatGPT did a very decent job overall, but missed out on a few important pros/cons.

For equity:

Another pro (which is a con for SAFEs) are potential tax benefits under Section 1202 Qualified Small Business Stock (QSBS) gains, as well as Section 1045 and Section 1244 for rollovers and losses. Those require that you held equity (along with many other requirements; please consult a tax advisor) - which some tax and securities attorneys may tell you is not satisfied by holding SAFEs or Convertible Notes (even though some SAFEs from Y-Combinator have a specific clause that says they should be treated as equity under Section 1202 - it's definitely an area with a lot of opinions!). Regardless of whether or not it qualifies for SAFEs, equity removes any doubt in terms of meeting that particular requirement for potential tax benefits.

For SAFEs:

Despite not being equity, during a liquidation event, many SAFEs will actually get paid out on par with Preferred Stock, senior any to Common Stock distributions. This can vary from SAFE to SAFE, so it's important to always check the specific deal terms.

Another con is that some SAFEs come with repurchase rights, which are very unfriendly to investors. They basically allow the issuer to repurchase the SAFEs from early investors, typically at the original face value or fair market value (FMV). However, how FMV is determined can be taken advantage of issuers who use timing (e.g. during the quick April 2020 downturn, prior to the immediate recovery and then some), and typically only companies that are doing very well will want to repurchase shares, so this can impose a cap on the upside potential of an investment, which goes against the asymmetric risk/reward profile that startup investors are often searching for.

A nuance that most investors do not appreciate (and ChatGPT may have missed) is that sometimes SAFE holders may have another hidden benefit of receiving less dilution during follow-on rounds. This is because their SAFE can be deferred from converting to equity under certain terms and circumstances; this means that, if it has a valuation cap and does convert further down the road, instead of getting diluted at each subsequent funding round along the way, SAFE investors won't start getting diluted until after they convert to equity. This comes with the flip-side of that coin, which is that by not converting to equity earlier, investors are potentially missing out on voting rights, dividends, and other benefits that being an equity holder conveys.

FINRA has a good, concise article on SAFEs: https://www.finra.org/investors/insights/safe-securities

I have also written answers to similar questions before on Crowdwise: https://crowdwise.org/forums/discussion/my-startup-is-asking-me-to-convert-my-safe-should-i-convert-the-safe-to-stock/