TL;DR: If you’re thinking about a seed round involving SAFEs or convertible notes, you can use Excel to model their effect on your common stock. No matter how simple the documents may seem, never just “sign and close” without thinking through the effects of dilution.
Download the open-source cap table and the example spreadsheet.
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Now you have your cap table, complete with equity plan and grants. In order to bring in some outside capital so you can make payroll, you find yourself pitching to angel investors. Simple Agreements for Future Equity (SAFEs) are easy to pull from Y Combinator’s website, but how can you get a sense of how they’ll affect your cap table before your lawyer starts billing? (Of course, you should always have your friendly startup lawyer help with models that you rely on to make decisions about investment terms, but the examples here can help give you a sense.)
Let’s say you’ve got an angel (in this case, Sitwell Ventures LP, a family office) on the hook for a $500,000 seed investment, and it is open to using a SAFE with a post-money valuation cap of $5 million, a SAFE with a discount of 20% to the next equity financing price, or a convertible note with 10% simple interest and a pre-money valuation cap of $5 million. You, as an intelligent founder, intend to talk with your company’s lawyer about how each instrument works, but how can you get a sense of how much dilution each might cause you as a founder? We’ll start with the simplest one to calculate, a SAFE with a post-money valuation cap. This is the one you can pull from Y Combinator’s website. You can read more about post-money SAFEs and why founders should be wary of them here.
SAFE with post-money valuation cap
Part of the reason Y Combinator has been trying to push this instrument as “standard” in the past few years, other than its investor-friendliness, is that it is relatively easy to model, at least for companies that have no other convertible securities outstanding. It works like this: If you invest $500,000 with a $5 million post-money cap, you get 10% ($500,000 / $5 million) of the fully diluted capitalization of the issuing company immediately before the next equity financing regardless of how many other SAFEs or convertible notes the issuing company issues (assuming the pre-money valuation in the next equity financing exceeds $5 million). That is, you are fully protected from dilution by later convertibles. That’s great for investors, and potentially terrible for founders – that dilution has to go somewhere, and it will hit the common stockholders rather than the new-money investors in the next equity financing.
You can see the modeling below and in the example spreadsheet, starting with the table labeled (A) in blue. The mechanics of the SAFE provide that to find the price at which the SAFE is converted into preferred stock in the next equity round, you divide the Post-Money Valuation Cap by the Company Capitalization. If the resulting price is higher than the new-money price in the next equity financing, you’d use the latter as the SAFE conversion price instead. Company Capitalization includes all outstanding stock, the whole option pool, and all converting securities, including the SAFE itself. This requires a circular calculation in Excel, so ensure that circular calculations are turned on. (Ignore the FD % Post-financing column for now.)
Convertible note with pre-money valuation cap
A pre-money valuation cap is similar to a post-money cap except that it does not take into account SAFEs and convertible notes when determining the Company Capitalization used to calculate the conversion price. Sitwell Ventures knows that a post-money cap is more investor-friendly, but it is willing to offer a convertible note with a pre-money cap as long as you agree to a 10% interest rate. Is that a better deal for the common stock?
It depends. You’ll need to model them side by side and think through how long the note might be accruing interest, whether you might need to raise additional bridge financing, what the size and valuation of the next financing round might be, and what the maturity of the note will be (and what happens at maturity, which is beyond the scope of this section).
The example spreadsheet, with the table labeled (B) in green, shows the effect of the accrual of interest and the pre-money cap. To calculate the interest, estimate when your next equity financing might be based on your runway, find the number of days between the issuance of the note and the conversion of the note, divide the interest rate by 365, multiply that by the number of days, and multiply that by the original principal amount. Then add that product to the original principal amount to find the total conversion amount. (“SHL form” refers to this publicly available form of convertible note published by my colleague Jose Ancer. The example spreadsheet references a pre-money version, but there is a post-money version as well.)
To find the conversion price based on the pre-money valuation cap, divide the cap by the fully diluted capitalization of the company, excluding the convertible note and any other convertible securities. Then divide the total conversion amount by that price to find the number of conversion shares. (Lawyers always round down when calculating a number of shares to be issued based on a total investment and a price – issued shares need to be “fully paid.”)
As a side note, pay attention in the form of note you use how interest is treated. Usually it is accrued as simple interest and converted into equity along with the principal. Sometimes, however, investors require it to be paid in cash periodically, and just the principal is converted. We seldom see compounding interest in convertible notes, but it’s worth keeping an eye out in the current investor-friendly climate. Ask your trusty startup lawyer if you have any doubt about how to account for interest.
SAFE with discount
SAFEs or convertible notes with a discount and no cap are the easiest to understand conceptually but the toughest to model in a useful way before you get an equity financing term sheet. “Discount” means a set discount to the purchase price of the new money in the next equity round. It’s a good way to avoid talking about any kind of current or expected company valuation (especially since many founders and even investors confuse the concepts of valuation and valuation cap). Angel investors can piggyback on the terms of a later round and get a bonus for their earlier, riskier investment.
To understand how a SAFE or note with a discount might convert, you essentially need to model the whole next round, called Series A in the example spreadsheet. The basic inputs are pre-money valuation, amount of new money coming in, and a target available option pool size. (VCs will usually insist on an option-pool expansion for post-round hiring that will be included in the pre-money and thus will not dilute the VCs. You can omit this step for back-of-the-envelope modeling if you want to keep things simpler.) You can also include a target Series A closing date if you need to calculate accrued interest on a convertible note.
The basic way to find the Series A price is to divide the pre-money valuation by the pre-money capitalization. It becomes trickier when you need to include more than just the fully diluted share count in the pre-money capitalization. Sophisticated investors will usually insist that all convertible notes and SAFEs be included in the pre-money capitalization so as not to dilute the new money. Their argument is that if they bargained for 10% of the company based on the pre-money valuation and the size of the new investment, that’s what they should get, regardless of the note or SAFE conversions. For example, if the agreed-upon pre-money valuation is $8 million and the new investor puts in $2 million, the investor will say it should get 10% of the $10 million post-money value ($2M / ($8M + $2M)), meaning any shares from converting securities and an option pool expansion are included in the $8 million.
This, too, requires a circular calculation in Excel, so ensure circular calculations are turned on. In the separate table that you built to calculate the number of conversion shares from the SAFE, insert a placeholder (such as 0) for the number of conversion shares, include that number of shares in the Pre-money Capitalization number for the Series A calculation, then find an initial Series A price. Once you have that Series A price, plug it into Series A New Money Price in the SAFE table and find the discounted SAFE price (subtract the discount from 1, then multiply that by the Series A price). Then, in the cell with the placeholder, divide the conversion amount by the SAFE price to find the number of conversion shares. That should ensure the circularity of the formula.
In any worksheets involving circular formulas, I usually turn AutoSave off and save manually via ctrl+S after every successful calculation – it can be a nightmare to untangle an error, and it’s often easier just to exit without saving and recreate what you were doing before the error. For those who like to plan ahead, using the IFERROR() function in any cell that performs division in order to avoid divide-by-zero chaos by replacing any error with a zero can save some untangling later.
For more on the Series A model and a similar method of calculating a pre-money option pool increase, please see Section 03: First preferred equity financing and pool expansion.
Lawyer note: As the SAFE with Discount section makes clear, SAFEs and convertible notes often convert at lower prices relative to what the new-money investors are paying. Each different price translates into a different subseries of preferred stock. For example, in a Series A round, the new money might be called Series A-1, SAFE conversions at two different valuation caps might be called Series A-2 and Series A-3, and a note conversion at a discount might be Series A-4. This is important for ensuring that the liquidation preference for preferred stock (i.e., the amount that each share of preferred stock is entitled to receive in an exit in preference to the common stock if the preferred does not convert to common) matches what was actually paid, so that the lower-priced shares do not receive a windfall in an exit. That is a different concept from priority of payment – within the same round, conversion shares and new-money shares will be pari passu, meaning no subseries is paid before the others.
Next topic: First preferred equity round and pool expansion
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