The shortcomings of SAFE notes (simple agreement for future equity) are coming home to roost; ironically, entrepreneurs are paying the price. Y Combinator invented the notes with a noble goal: “we intend the SAFE to remain fair to both investors and founders.” But many SAFE notes that entrepreneurs are quick to issue now have a nasty bite: much more dilution than the issuers thought when they signed those documents.
Since the SAFE was created in 2013, many optimistic entrepreneurs have flocked to raise successive “mini-equity-rounds” using the SAFE format or traditional convertible notes. Little thought is given to the potential impact of these notes on future valuation, and their dilution implications are often overlooked. This can be especially appealing when raising individually small checks from unsophisticated angel and seed investors. And it can be a poisonous recipe.
We have observed the following in our own recent direct experience investing in SAFE and convertible notes: that many founders have a tendency to associate the valuation cap on a note with the future floor for an equity round; that they further assume that any note discount implies the minimum premium for the next equity round; and that many founders don’t do the basic dilution math associated with what happens to their personal ownership stakes when these notes actually convert into equity.
By kicking the valuation can down the road, often multiple times, a hangover effect develops: Entrepreneurs who don’t do the capitalization table math end up owning less of their company’s equity than they thought they did. And when an equity round is inevitably priced, entrepreneurs don’t like the founder dilution numbers at all. But they can’t blame the VC, they can’t blame the angels, so that means they can only blame… oops!
How did this happen and what does it mean?
While there are proper uses of notes (to bridge the company to achieve a major milestone, or driven by insiders’ willingness to extend runway), there also are troubling and frequent improper uses (to postpone pricing equity until valuation is higher or to ignore the implicit message associated with being unable to find a lead investor to price the round on terms that the founders like).
Why is this troubling? Because it has become more common for VC funds to pass on investing in deals altogether, solely because the waterfall of notes would consume too much equity. If outstanding notes prevent a new lead investor from meeting their fund’s required ownership targets without triggering a complete company recapitalization, a null set of equity distribution possibilities may arise.
It is critically important that VCs understand cap table math; unfortunately, many do not.
Some takeaways: It is critically important that VCs understand cap table math; unfortunately, many do not. Similarly, many CEOs don’t realize the impact that multiple SAFE notes at various valuation caps have on the capitalization table and how these notes can negatively impact the financial viability of the company moving forward.
At its core, this issue points to the lack of understanding about the importance of post-money valuation by both entrepreneurs and investors. While VC deals remain marketed on a pre-money basis, sophisticated investors know that what matters most is the post-money (how much of the company will I own after all of the new shares have been issued). Unfortunately, what the CEO/founder forgets most often is that the notes have a multiplier effect in the post-money calculation; the more notes and the further the cap is from the new priced equity, the greater the variance between actual and nominal pre- and post-money valuations.
SAFE notes gone awry create undue negotiating tension between CEOs/founders and new investors, especially if this interaction occurs during the first priced equity round, because it is truly the first time founders and other common stockholders see the dilution in real terms. What often gets overlooked by founding teams when SAFE or convertible notes are issued is that a majority of the dilution has already occurred, by issuing notes. When the CEO sees his or her ownership fall from 78 percent to 35 percent in one fell swoop, they often assume and blame the new financing structure or the price. This may actually be a self-inflicted wound.
It is rare that a company begins marketing a first institutional-priced equity round alongside a converting note with a pro-forma “as converted” cap table in-hand. A proactive CEO should have company counsel prepare a pro-forma cap table of the company before issuing any notes, so the impact is fully understood before a note investment is ever accepted.
In more traditional convertible debt, it is possible to provide for voluntary note conversion under specific circumstances. Maturity/conversion ahead of a new equity round can greatly dilute all existing shareholders, but also can get a new lead investor “over the hump.” Multiple series of notes can create “dilution waterfalls” and hamper future priced rounds, as large portions of the pie have already been carved out to founders, converted note holders and Series A investors. In these cases, the only valuations that makes sense for a Series B lead investor force the dreaded “down round.”
While “rocket ship” companies can overcome the structural issues of rolling notes, there are many more SAFE issuers than there are rocket ships.
Many CEOs do not understand the true cost of the future equity they are selling in a SAFE or convertible note instrument, especially in the all-too-frequent “waterfall” scenario. Companies should always gauge whether notes are setting up the company for success in a future round, or whether additional notes are suitable at the company’s current stage of development. Issuer and investor awareness is key to minimizing the negative impact moving forward, and can help improve capital efficiency in venture capital for early-stage companies.
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