TL;DR: Before agreeing to multiple post-money SAFE rounds to save time and money in the short run, founders should think through how much money they could save in dilution in the long run by switching to a simple equity financing.
Download the example spreadsheet for this post.
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Resistance is futile.
Although Y Combinator has not yet succeeded in assimilating every startup into a single VC- (or AI-?) controlled collective, its form financing instruments dominate the world of early-stage startup financing. Much digital ink has been spilled about the pros and cons of the so-called post-money SAFE, which YC introduced in 2019 or thereabouts. (A couple of our favorites are on Silicon Hills Lawyer and PNW Startup Lawyer. Our colleague Jose Ancer suggested a simple but helpful fix for the worst part of the post-money SAFE in a separate post on Silicon Hills Lawyer.) As we sometimes say, YC initially introduced the most founder-friendly early-stage funding instrument, followed by the least founder-friendly early-stage funding instrument. But like it or not, post-money SAFEs are everywhere.
The point of this post is not to convince you that you can talk investors out of the post-money SAFE just because its economics are less than stellar, and less than logical, for founders and early common holders. If you’re taking your first outside money and an angel investor insists on using the post-money SAFE with no modifications, you may not have a choice. Rather, a question we get often from founders is how they should handle their second (or third, and so on) seed raise before a Series A. As SAFEs have become more standardized, early-stage founders are keen to minimize transaction costs and time to closing and investors enjoy the favorable economics of post-money SAFEs before a “real” equity round. [FN] But the “SAFE stack,” i.e., taking multiple rounds of investment as post-money SAFEs, will make you regret joining the hive mind.
[FN: This has led to many investors trying to have their cake and eat it too, by combining the simplicity of a SAFE with a lengthy side letter, which can include board seats, observer rights, permanent participation rights and other “major investor” rights, information and inspection rights, and other investor rights more appropriate for priced equity rounds. Most galling are the requests that the issuer reimburse the VCs $20,000 or more for legal fees incurred in having their biglaw firms conduct minimal diligence and negotiate the side letter.]
The big question is usually something like, “Should we just do another post-money SAFE, or should we try for a simple priced round (such as a Series Seed round) at the same post-money valuation?” If you’ve ever worked with a good lawyer, you know the answer is, “It depends.” Every situation is different, and if your company is confronted with this question, you’ll need to work with your trusty startup lawyer to model out what the difference would look like given your specific facts.
As a busy, cash-strapped founder, you’d be forgiven for assuming, “There’s no real difference between a $2.5 million SAFE with a $12 million post-money valuation cap and a $2.5 million priced round at a $12 million post-money valuation – in fact, with the SAFE I’ll save $15,000 in transaction costs and a few weeks of negotiating a bunch of paperwork that gives the investors extra rights, and I won’t have to increase the option pool!” Well, that assumption might have just cost the early common (including yourself) hundreds of thousands or even millions in equity value. [FN]
[FN: The example spreadsheet for this post ignores transaction costs, timing of closing, and the fact that investors may negotiate extra rights in a priced round. These are all relevant, but timing (in some cases) and investor rights (in most cases) are much more important than transaction costs. In addition, as I pointed out above, the line between true early-stage bridge rounds and full-blown equity rounds is getting more blurry. If you have to spend weeks negotiating a lengthy side letter along with the SAFE and have to reimburse investor counsel $20,000 (in addition to paying your own counsel), what are you really saving?]
As a quick refresher, in a rational investment structure (not a post-money SAFE), as a startup raises more money on a convertible instrument or priced equity round, the valuation of the startup increases dollar for dollar as the amount raised increases. That isn’t the case with post-money SAFEs – the post-money valuation is fixed, so rather than each dollar of investment increasing the post-money valuation, it instead decreases the pre-money valuation by a dollar.
In addition to causing finance professionals to scratch their heads, this irrational attribute of the post-money cap SAFE creates odd incentives for the startup. At a high level, the economic incentive is to convert the SAFEs as early as possible and avoid raising additional SAFEs or convertible notes. That means a startup raising a small round that would ordinarily be structured as an additional SAFE or convertible note round would often benefit from much better economics by structuring the round as a priced equity round to convert the SAFEs.
This post illustrates a typical example scenario (which you can modify using Excel) based on the open-source cap table showing the danger of the “SAFE stack” for founders and other early common stockholders.
As a default in the example spreadsheet, the startup has raised $1 million on a $5 million post-money cap SAFE and $1.3 million on a $7 million post-money cap SAFE. A new investor proposes a $2.5 million investment at a $12 million post-money valuation. The investor assumes it is indifferent between a post-money SAFE and a Series Seed because, it figures, either way it gets 20.83% of the Company on a fully diluted basis before the next round. Which is better for the founders and other common holders?
To answer this question, we need to model a few things. To get a baseline, here is a pre-financing cap table (called Time 0 (formation)) with arbitrary share allocations among two founders, an early employee and a stock plan or option pool:
As the next part of the baseline, the first two SAFE rounds (Time 1 (angel rounds)):
Now two paths diverge: another SAFE or a Series Seed priced round at Time 2A/2B (SAFE seed round/Series Seed equity round)? Unfortunately, we can’t just model those in a vacuum. The investor in our hypothetical did, which led it to conclude that either way, it would receive 20.83% of the company ($2.5 million investment divided by a $12 million post-money valuation or cap) as of immediately before the next equity financing. That’s true, but it doesn’t tell the whole story. We need to model that projected next equity financing (Time 3 (Series A)) in order to see how a Time 2A SAFE (seed round) would convert given the existence of the two Time 1 SAFEs (angel round), and what effect that would have on the founders’ dilution relative to a Time 2B Series Seed equity round.
In the example spreadsheet, the Time 2B Series Seed model and the Time 3 Series A models use concepts already discussed on this site and illustrated in the open-source cap table. I will not rehash those concepts here.
As you can see in Time 3 (the Series A financing), the difference between having a $2.5 million investment in the form of a $12M post-money cap SAFE versus a $12M post-money valuation Series Seed round can be massive. This is mainly because the Time 1 SAFEs (angel round) are protected from dilution from the Time 2B SAFEs (seed round), whereas the Series Seed shares are diluted just like everyone else’s. The anti-dilution protection has the biggest impact on the differences to the cap table between the two paths. In our view, the latter is the more rational investment structure.
To wrap up the example, the common holders lose about $2.2 million in equity value at the time of a Series A raise at a $35 million post-money valuation by taking the quick fix of a second post-money SAFE round …
… whereas they gain about $2.2 million by doing a simple Series Seed equity round with the same economic terms instead, even if the option pool is expanded in both the Series Seed round and the Series A round.
It’s worth noting that an investor choosing between a SAFE and an equity round in Time 2 does not experience a huge difference between those alternatives in terms of dilution by a later Series A; although the investor shouldn’t be totally indifferent, it’s a helpful fact in negotiating that the founders take a far bigger hit with the extra SAFE round. Additionally, the certainty in ownership caused by the Series Seed equity round in Time 2 benefits all parties.
Spending some extra money in the short term to convert outstanding post-money SAFEs as soon as possible, rather than closing another simple SAFE round, is an odd incentive created by the migration from pre-money SAFEs to post-money SAFEs. But while resisting the concept of post-money SAFEs may indeed be a lost cause, founders who think through the consequences of the “SAFE stack” (along with their company’s trusty startup lawyer!) may find themselves saving millions of dollars down the line.
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Thanks to Brian Alford for his invaluable contributions to this post!
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