A Fix for Post-Money SAFEs: The Math and a Redline

Background reading: Why Startups Shouldn’t Use YC’s Post-Money SAFE

A very quick review of the high-level economic problem with the Post-money SAFE structure that YC promoted a few years ago; and which is only in recent quarters becoming more visible to founders as their seed rounds start to convert:

The stated value proposition of the post-money SAFE, relative to the traditional pre-money SAFE, was that it delivered investors far more clarity over how much of the cap table they were buying. If they put in $1 million on a $10 million post-money SAFE, they were buying 10% of the company today, regardless of what the current cap table looks like. This is actually a good thing. Clarity is great.

The hidden value proposition for investors of the post-money SAFE, and which has cost founders enormously by not understanding its implicationswas an extreme level of anti-dilution protection built into the post-money SAFE. Any SAFEs or notes that you issue after the post-money SAFE round, but before a Series A, do not dilute the investors; they dilute only the common stock (founders and employees). This is the case even if the 2nd or 3rd round of SAFEs is an up-round with a higher valuation cap.

This was and remains crazy, and totally unnecessary in light of the stated purpose of post-money SAFEs; which was for investors to know what they are buying on the day of their closing. When you buy equity you are able to calculate the ownership you are purchasing at closing, but equity rounds virtually never, not even in the most investor-slanted deals, have full anti-dilution protection for post-closing investment. Why should Post-Money SAFEs give investors that? They shouldn’t, and this was an egregious (but in my opinion, deliberately obfuscated) over-step in startup financing template design.

We posted here a very simple redline (in track changes) of what needs to be edited on YC’s post-money SAFE to eliminate the terrible anti-dilution mechanics. Again, it’s worth emphasizing that this redlined safe still gives investors the stated benefit of the post-money structure, which is to know what % of the cap table they are getting as of their closing. What it changes is that it makes post-closing issuances proportionately dilutive to both founders and investors, just as they would (and should) be in any other kind of financing structure.

A colleague of mine also designed a very helpful model (in Google Sheets) breaking down the mathematical (economic) differences between a typical pre-money SAFE, post-money SAFE, and our suggested redlined post-money SAFE. We know engineers in particular love seeing the numbers.

To give a high-level idea of the economic implications, assuming the following:

SAFE Round 1: $5M pre-money cap or $6.5M post-money cap ($1.5M invested)

SAFE Round 2: $10M pre-money cap or $12M post-money cap ($2M invested)

Series A round: $25M pre-money, $31M post-money ($6M new money), 10% post-available pool.

In Series A dollars (company value as of Series A closing), common stockholders lose $912,000 in moving from the traditional pre-money SAFE to YC’s preferred post-money SAFE. Fast-forward to an exit years later, and you’re talking easily millions or even tens of millions of dollars in lost value from simply changing the template.

Again in Series A dollars, common stockholders gain appx. $1.2 million in using the redlined post-money SAFE relative to YC’s post-money SAFE. The addition of just a few extra clarificatory words (which eliminate the hidden anti-dilution protections for investors) shift $1.2 million in Series A value from investors to the common stock; which again could easily be >$10 million by exit. All with just a few tweaks of language.

If this isn’t clear already: the stakes here are extremely high. And anyone suggesting that mindlessly using an investor or accelerator’s preferred templates is “saving” founders money (by reducing legal fees) is either hilariously uninformed, or lying out of their teeth. Tread carefully, and stay well-counseled.

Disclaimer: The model presented above is purely a hypothetical based on general math mechanics of SAFE and Series A rounds. The specific outcome in your company’s case will be dependent on the facts and circumstances, and you should always use experienced, trusted advisors to avoid missteps.  

“No Code” v. “Open Source” Approaches to Early-Stage Startup Law

TL;DR: Fully automated startup financing tools often utilize templates designed by and for investors. They claim to save founders money by reducing legal fees, but founders often end up giving 10-20x+ (relative to fees) away in cap table value as a result of the inflexibility and lack of trusted oversight over the “code.” Using vetted and trusted templates, while still incorporating non-conflicted counsel into the negotiation and review process, provides the best of both worlds: common starting points, with flexibility and trust.

Background reading:

“No Code” is a term I’ve been hearing more often lately. It refers to new tools that allow users to “program” various processes without actually having to code them; effectively modules of tools that are interoperable and allow building semi-customized programs without needing to actually get into coding. Very useful.

While “no code” seems to certainly have a good value proposition for many user contexts, it occurred to me recently that “no code” is good short-hand for the startup financing approach that parts of the investor community, and to some extent the tech automation community, has tried to peddle onto startup ecosystems and founders. By pushing the minimization of “friction” in funding (just sign fully automated templates), with the key “carrot” being the reduction in legal fees, these players want founders to think that it’s in their interests to simply close their financings with a few clicks, instead of leveraging lawyers to actually negotiate and flexibly customize the “code” (language).

The reasons behind why tech automation companies would push this perspective are obvious: they want to make money by selling you automation tools. But the reasons why the investor community is incentivized to also back this approach require a bit more explanation. For one example, see: Why Startups Should Avoid YC’s Post-Money SAFE.  First-time founders are what you would call “one shot” players in the startup ecosystem. They are new, inexperienced, and laser-focused on the single company they are building. Investors, including prominent accelerators, are instead repeat players. They are highly experienced, resource-rich, and stand to benefit significantly if they can sway the norms/”standards” of the market in their favor.

The most prominent, high-brand investors have all kinds of microphones and mechanisms for nudging the market in ways to make themselves more money, especially because the founders usually absorbing the content have little experience and knowledge for assessing substance. One of those ways is to push templates that they (the investors) themselves have drafted, and create an impression that those templates are some kind of standard that everyone should adhere to without any customization.  Of course, they’re far too clever to come out and say overtly that these templates are designed to make investors more money, so instead they’ll latch on to more palatable messaging: these templates will save you legal fees and help you close faster.

To summarize, investors and tech automation companies push the “no code” approach to early-stage funding out of self-interest, but they use the “save you legal fees” marketing message to get founders to buy in. The problem that not enough people talk about is that by taking the “no code” approach, founders become permanently stuck with the pre-packaged and inflexible code (contract language) that these players provide. And as I’ve written extensively on this blog, the code is dirty.

I want to emphasize the word permanently here. Look up what most “no code” tools do. They help you sort contacts, build a spreadsheet, maybe build some low-stakes automation processes. Good stuff, but very different from, say, permanently signing contractual terms for millions of dollars that in the long-run can have billion-dollar economic and power implications. In startup funding, we are talking about executing on issues that are literally 1000x more consequential, and un-modifiable once signed, than all the other areas where “no code” approaches are applied.

Having a trusted advisor (lawyer) make even just a few tweaks to a template document, or flexibly choosing a better-fit template to begin with, can have million/billion-dollar implications for a company. Given the enormous stakes involved – what bank account exit money goes into, and who gets ultimate decision-making power over an enterprise – founders need to think very hard about whether getting boxed into an inflexible automation tool, in order to save at most $5-25k in fees in a seed financing, is actually the smart approach. I see inexperienced founders regularly handing over millions in cap table value to investors, and in some instances unwittingly giving those investors strong “choke point” power over their governance, all because the founders were convinced that lawyers are a boogeyman extracting money to just push paper and hand-waive with no value-add.

Notice here that I’m not advocating for a wholesale reversion to the old-school days of simply letting lawyers take full control of the negotiation process, using whatever forms and standards they want. There is enormous value in having market-respected starting points for negotiation; sets of templates known and understood by investors, and trusted by lawyers who represent companies (and not investors), that can then be flexibly modified to arrive at a final deal that makes sense for a specific context. By having your lawyers (who hopefully aren’t conflicted with the investors they’re negotiating with) draft initial deal docs from a reputable template, the lawyers on the investor side can redline against that familiar starting point, instantly reducing the amount of up-front negotiation by 80% because they aren’t working with language (code) they’ve never seen.

What I’m effectively advocating for here is an “open source” approach to high-stakes early-stage startup law. It allows for some standardization (efficiency), but also flexible customization, to ensure every deal is fair for the parties involved. And importantly, it ensures that the templatization and customization is transparent and “open,” with lawyers from both the investor and startup (company-side) community participating; instead of the one-sided “here are the standards” model that certain VCs have tried to adopt. We can deliver founders and investors substantial efficiencies in fundraising, without using “saving fees” as an excuse for burdening founders with inflexibility and “dirty” code (contracts) that simply aren’t justified.

With this in mind, I’ve published a Seed Round Template Library, with links to templates for convertible notes, pre-money SAFEs, seed equity, and full NVCA docs, along with a few educational articles. By using these starting points, founders can have the efficiencies of working from vetted and trusted language, but without the enormous costs of using fully automated templates designed to favor investors.

Myths and Lies about Seed Equity for Seed Rounds

TL;DR: The release of the Post-Money SAFE structure, which is the worst possible way to raise seed money for most startups, has incentivized seed investors to perpetuate various myths and lies about alternatives (particularly about seed equity), in order to push founders to accept bad economics. Founders need to look past the spin and self-interested advice, to ensure they are assessing all the variables clearly.

The fundraising advice that vocal investors, many with blogs and twitter accounts, give to first-time founders often closely tracks their own incentives and self-interest. For example, a few years ago before the creation of the Post-Money SAFE, many early-stage investors complained that Pre-Money SAFEs had all kinds of problems, and that founders should strongly consider equity for their seed rounds. That was, of course, because Pre-Money SAFEs were very company (founder) friendly from an economic and governance rights standpoint, and those investors got more of the cap table by hardening their positions via an equity round with extra rights.

But now that YC has taken it upon itself to promote the Post-Money SAFE, which has terrible economics for companies/founders and is great for early-stage investors, suddenly the narrative has flipped. Now many of those same investors sing the praises of SAFE rounds, and have spun all kinds of myths and lies about why seed equity is apparently now such a terrible structure. The point of this post is to dispel some of those myths and lies.

Myth / Lie #1In an equity round you have to give investors a board seat.

Simple, you don’t. There’s nothing inherent in doing an equity round that requires giving investors a Board (of Directors) seat, and we’ve seen plenty of equity rounds that don’t. On the flip side, some SAFE and convertible note rounds will involve giving a Board seat to investors. Whether or not giving investors a Board seat in your seed round is appropriate or a good idea is entirely contextual, but there’s no connection to that negotiation point and the general structure of the round.

See also: Pre-Series A Boards.

Myth / Lie #2Equity rounds require you to close all of your investors at once, instead of with “rolling closings.”

Nope. You can do “rolling closings” quite easily in a seed equity round, so there’s no inherent need to have all of the money rounded up at once. Sometimes investors will place a limit of 120-180 days to do those rolling closings, but other times there’s no deadline and it’s open-ended.

Myth / Lie #3: Equity rounds require you to have a lead investor.

It certainly helps to have a lead investor – someone writing a big enough check, and with their own counsel – to do some light review of the equity docs in a seed equity round, but again there’s nothing inherent in the equity structure that requires it. It’s more about the comfort level of the investors. I have seen “party” seed equity rounds where everyone writes a $50K-200K check. It works fine, particularly now that there are relatively well-known seed equity templates out there that can be referenced and recognized among sets of specialized ECVC lawyers.

Myth / Lie #4: Equity rounds take months to close.

I’ve seen seed equity rounds go from term sheet to money in the bank in 2 weeks. Now that’s definitely on the faster end of the norm, and 3-4 weeks is more common. It’s not lightning fast, but neither is it the dragged-out process that some investors suggest it is. The primary drivers of a lengthier timeline are diligence issues (cleanup) and investor negotiations/delays. Nothing inherent in a seed equity round structure requires it to take a long time, given that well-used templates require minimal customization.

Given how high-stakes the terms you’re committing to in any fundraising are, there is some value in slowing down enough to really know what you’re getting into. See: Negotiation is Relationship Building.

Myth / Lie #5Equity rounds require paying $50-100K in legal fees.

It is true that any equity structure is likely to require somewhat higher legal fees than a SAFE or convertible note round, but seed equity, which is a simplified equity structure relative to full NVCA-style docs (which are more commonly used for Series A and later rounds) isn’t nearly as expensive to close on as some investors suggest. On the leanest end I’ve seen seed equity close for about $10-15K in company-side legal fees, and $5K on the investor side, but more realistically you’re going to be closer to $20K company side and $10K investor side, so about $30K total; possibly higher if you use very expensive firms. See: Automated Law v. Solos v. Boutiques v. BigLaw for more on legal fees and firm structures.

A good ballpark of fees spent from beginning to end for a multi-million dollar SAFE or convertible note round is $2.5K-$5K, so let’s say the delta between convertibles and seed equity is ~$25K in legal fees. The question then becomes, are the positives to closing on a seed equity round worth more than $25K? Very often they are. Easily.

Especially if your investors are asking for a Post-Money SAFE, which has extremely expensive (long-term) anti-dilution mechanics built into it if you end up needing (and likely will) more seed money later, the difference in dilution between a seed equity raise and a Post-Money SAFE can often be multiple percentage points on your cap table. If the difference is 1%, $25K implies a $2.5 million company valuation. If it’s 2%, it’s $1.25 million.

I have seen many companies raising at $10 million, $15 million, even higher valuations in their seed rounds, with multiple million in funding, and yet their investors act as if the extra cost of a seed equity round is so burdensome that the founders should just do a Post-Money SAFE; which in the long-run hands multiple percentage points on the cap table to the seed investors. Basically they are telling founders that they should avoid paying the equivalent of 0.25-0.5% of their enterprise value now in cash for a more hardened, company-favorable deal structure, and instead give 1-2% more of the company as equity (with upside) to the seed investors, which in the long run could be worth millions for the highest-growth companies. That is a horrible tradeoff for the founders.

Translation: “Don’t spend $25K in legal fees now. That’s a “waste of money.” Instead stick to our preferred template and give us 6-7 figures worth of extra equity!”

This isn’t to say that equity is always the right answer for a seed raise. Hardly. Sometimes pre-money SAFEs make sense. Sometimes convertible notes do. I’m a fan of modifying a convertible note to have the economics behave more like equity, but with the streamlined structure of a note; the best of both worlds. And sometimes your investors will demand that you give them a full NVCA suite of docs. Context matters, and so do the numbers.

There’s no universal answer to how you should structure your seed round, because every company is different, and different investors and founders have different expectations, priorities, and preferences. However, not falling for the most common myths and lies that investors give to push you in favor of their preferred structure – which usually is whatever makes them more money – will ensure your eyes are wide open, and you can assess the positives and negatives clearly.

The Carta SAFE for Seed Rounds

Background reading:

As I’ve written in various places (see above), a significant problem that has emerged in startup ecosystems involves certain investor organizations pushing startups to adopt their preferred financing templates. Predictably those templates are often riddled with issues that favor the interests of the money. Of course these organizations are far too clever to come out and state transparently, “we want you to use this document because it makes us and other investors more money,” so they spin other narratives about saving founders time, or reducing legal fees; even though the “cost” to founders is often orders of magnitude higher than whatever they might be “saving” by mindlessly signing the templates.

This dynamic was most visible with YC’s announcement of the Post-Money SAFE, which implemented economic concepts exorbitantly favorable to seed investors (including YC of course), but was marketed as a way to (air quotes) “help” founders have more “clarity” about their cap table. YC, their long list of positive impacts on the ecosystem notwithstanding, is still an investor with lots of mouths to feed. No one should’ve been surprised that it would use its brand leverage to push a more investor-favorable document onto startups, particularly now that, with its brand having significantly matured, it no longer needs to rely as much on “founder friendliness” to attract startups.

Carta, the dominant (by far) capitalization SaaS used by startups, recently announced that it is enabling automated SAFE financing on its platform. Interesting news, and I’m sure it’ll save teams planning on closing SAFE financings a bit of hassle. But automated SAFE closings have been available on other platforms, like Clerky, for some time, and realistically the technology behind it is hardly earth-shattering. Given that SAFEs are utilized far more in California than in the rest of the market, that’s probably where the automation will have the most impact.

What I find much more interesting, and relevant to topics I write about, is that Carta chose to tweak the YC SAFE docs and create a “Carta SAFE.” Companies can still close on YC’s Pre-Money or Post-Money SAFE templates, but they also have the option of a Pre-Money or Post-Money “Carta SAFE.” The changes themselves are fairly innocuous, but helpful and balanced. More importantly, I think it’s worth recognizing the valuable role that an organization like Carta could play in promoting various template financing structures to startups.

YC is a venture capitalist, and thus highly biased in the terms it purports to offer as “standard.” They lost tremendous credibility among the legal and startup community – although surely gained favor among VCs – with their 180 on the Post-Money SAFE. They absolutely deserve respect for their track record of picking successful startups, but lines have been crossed with respect to any facade of “founder friendliness” in their template standards.

Carta, however, is a technology company that (as far as I know) is not investing in dozens of startups every year. Carta has far less reason to favor an investor-biased document, and thus potentially has far more credibility in swaying market “standards” in a more balanced direction. This is visible in how they’ve implemented their automated seed financings and templates, relative to how YC pushed out the Post-money SAFE.

Go to YC’s website, and you can’t even find the old pre-money SAFEs with more company-favorable economics and terms. All you have is the new (profoundly investor-biased) Post-Money docs for download. This simple fact has actually caused huge confusion among inexperienced founders, who often aren’t even aware that YC dramatically changed their forms and economics, and thus (thinking they are doing themselves favors) simply download and execute the forms on YC’s site. YC could’ve very easily offered up the new Post-Money SAFEs, while leaving the old forms also available for download, with clear prompting to founders to work with advisors to decide which form they prefer. Instead, YC consciously chose to promote only the new forms, signaling a clear desire to change the market “standard” in favor of investors.

Contrast that with Carta. The Pre-Money v. Post-Money distinction is front and center in their UI, with both types of forms easily accessible to startups, and with helpful tools for comparing dilution from the different structures. This is a far more honest and transparent way for helpful templates to be offered to startup teams, without shady gimmicks or marketing spin to nudge them in favor of the money. It should be applauded.

Of course, I’m not going to wrap up this post without acknowledging that Carta still has bias. Who doesn’t? As an automation tech company, they are obviously biased toward automation and templates that enable automation. There are countless ways in which financing documents can (and often should) be negotiated and tweaked to make them a better fit for the unique context of a particular company raising money from particular investors. Sometimes convertible notes of various flavors make more sense. Other times seed equity. Other times the full suite of NVCA equity docs.

Despite growing traction among public templates, an enormous amount of investors and startups still take advantage of flexibility and customization in their deal docs, because the stakes are so high, the context and people involved so nuanced, and the terms so permanent, that it’s worth doing a bit of negotiation. If a few thousand dollars of legal fees can save you a few million in the long-run on your cap table, it doesn’t take advanced calculus to arrive at a decision.

In saying that, I’m obviously reflecting my own bias as company counsel to startups (and not investors). My job is to ensure startup teams are aware of all the options on the table for their financings and corporate governance. That of course includes bringing up when an automated template might make sense. Sometimes it does, often times it doesn’t. We can all stop pretending that serious lawyers are in any way threatened by tools like Carta or Clerky. I love these tools, because the last thing I enjoy spending my time on is shuffling cookie-cutter forms. Use the cookie-cutter when it makes sense, but make sure you really understand the tradeoffs and limitations, because a lot of very smart teams decide to put the cookie-cutter down and take a more “custom fit.”

Venture capitalists, together with Startups, are biased in favor of their own bank statements. Automation tech companies, like Carta, are biased in favor of hyper-standardization and automation. And high-end ECVC (Startup) lawyers, like me, are biased in favor of flexibility and customization. There’s no need to hide any of this. Every party has an important role to play in the ecosystem, and the interaction of all the moving parts ensures we all arrive at a reasonable equilibrium. All of that being said, I’m glad an organization like Carta has entered the template financing arena, because a well-branded but less biased player was sorely needed.

“Fixing” Convertible Note and SAFE Economics in Seed Rounds

TL;DR: In an equity round, including seed equity, any post-closing dilution is shared proportionately between investors and common stockholders (founders and employees). This is fair. Assuming no shenanigans and the business is increasing in value, why shouldn’t dilution be shared? Convertible notes and pre-money SAFEs have a math formula that makes them more dilutive to founders than an equity round with an equivalent valuation, by “protecting” seed investors from some post-closing dilution. Post-Money SAFEs are even worse. The solution is fairly simple: “fix” or harden the denominator in the conversion price formula, instead of having it dependent on complex language and variables. This gives everyone the benefit of a “floating” valuation that is so valuable in convertible instruments, while making post-closing dilution mechanics equivalent to an equity round.

Broadly speaking, there are 3 main instruments being used by startups in seed rounds: equity, convertible notes, and SAFEs. From a historical standpoint, equity (issuing actual stock at a fixed price) is the default instrument, but for reasons of speed and flexibility (on pricing), convertible notes and SAFEs have gained traction in early rounds smaller than about $2 million in total funding (the number in Silicon Valley is a bit higher).

Equity Math

While glossing over a few nuances, the formula for setting the price of stock sold in an equity round is fairly simple: pre-money valuation divided by capitalization. The higher the valuation, obviously the higher price. But importantly, the higher the capitalization (the denominator), the lower the price. In equity term sheet negotiations there is often some (necessary) back-and-forth around what actually gets included in the capitalization denominator. For example, being forced to put any increases in the option pool is fairly common. Somewhat less common but still extremely impactful is being forced to put all of your existing convertible instruments (notes or SAFEs) in the denominator. In this sense, two startups can have the same “pre-money valuation” but dramatically different actual stock prices (price paid by investors) if they negotiated different denominators.

Assumptions:

Pre-money Valuation: $10 million

Capitalization on your date of closing, including option pool increase in the round: 10 million shares

Math: valuation ($10 million) / capitalization (10 million shares) = investors pay $1 per share of preferred stock.

Simple enough. Fixed valuation, fixed capitalization, and you get a fixed price for easy modeling. Any financings (excluding down rounds) that happen after your equity round dilute the entire cap table proportionately. But the “math” for convertible notes and SAFEs is not so simple, and not as favorable as an equity round.

Convertible Note and Pre-Money SAFE Math (more dilutive)

In Why Convertible Notes and SAFES are extra dilutive I explained how the typical math of convertible notes and SAFEs makes them extra dilutive to founders/startups compared to an equity round. To summarize: because convertibles fail to “harden” the conversion math for the investors, convertibles allow seed investors to pack more shares into the denominator. Remember: higher denominator = lower price, which means the seed investors pay less and get more of the cap table even without changing the “valuation.” In an equity round, increases to the option pool after you close get absorbed by your seed investors pro-rata, but not so in typical convertible note math. Your seed note holders get “protected” from that dilution by including the pool increases in their denominator up until closing.

The fact that the denominator in convertible notes (and SAFEs, which are derived from convertible notes) isn’t fixed is actually a remnant from when convertible notes were traditionally used mostly for “bridge” rounds closed only a few weeks or months before a Series A. When your convertible round is truly a “bridge” for an equity raise in a few weeks, having your note investors get the same denominator as your Series A investors makes sense. But today seed rounds are being closed 2-3 years before a Series A. Keeping the denominator “open” for that long does not make sense.

So, keeping valuation constant, convertible notes and traditional pre-money SAFEs are more dilutive than an equity round because the denominator is larger. Why do startups use them then? Speed and flexibility.

First, given how early-stage fundraising and company-building has evolved, many (but certainly not all) seed rounds lack a true lead willing to hire their own counsel and negotiate hardened seed equity terms. Also, at the very early stages of a startup, pegging the exact valuation that investors are willing to pay can be difficult given the lack of data and track record. The valuation cap concept in Notes and SAFEs allows startups to set a proxy for the valuation, while flexibly allowing seed investors to get a lower price if the Series A valuation ends up in fact being lower than what was originally expected. Valuation flexibility (via a cap, as opposed to a fixed valuation) is a big reason why, despite the advantages of seed equity, many young startups still opt for convertibles. The ability to incrementally increase the cap over time, as milestones are reached, is also seen as valuable flexibility offered by convertible instruments.

Post-Money SAFE Math (even more dilutive)

A while back Y Combinator completely re-vamped the math behind their SAFEs, converting it to a post-money formula. See: Why Startups shouldn’t use YC’s Post-Money SAFE. Rather than setting a pre-money valuation cap, startups using the post-money SAFE are now required to set a post-money valuation, including all money they expect to raise as seed. YC’s stated reason for changing the math on the SAFE was to make it “easier” to model how much a company is giving to seed investors, but as discussed in the blog post, anyone who’s deep in this game and unbiased knows that claim is smoke and mirrors. The formula change made the SAFE structure far more favorable to investors (including YC) economically.

What was really happening was that because pre-money SAFEs had exactly zero accountability protections relative to seed equity and convertible notes – the maturity date in notes constrains the ability of startups to keep raising more and more rounds without converting the seed round into equity – seed investors in SAFEs were getting burned by startups raising SAFE rounds for years and years without ever converting. As an investor, YC itself was getting burned. So they changed the SAFE to be more investor friendly, benefiting YC and all seed investors.

But in the opinion of many ecosystem players, including lawyers focused on representing companies (and not the investor community), the change was egregiously one-sided. It effectively forces founders and employees (common stockholders) to absorb all dilution for any other convertible note or SAFE rounds that they raise after the post-money SAFE round, even if the valuation cap is higher. That’s an extremely high price to pay just for making modeling seed rounds a little easier. I have a better (fairer) idea.

“Fix” the Denominator in Notes and Pre-Money SAFEs (same dilution as equity round)

The benefit of convertible notes and SAFEs is flexibility and speed. They are simpler, and allow you to have a “floating” (flexible) valuation (cap) that helps companies and investors get aligned despite the uncertainty. This “floating numerator” is important and valuable.

But as discussed above, while the benefit of notes/SAFEs is a more flexible numerator (valuation), the benefit of seed equity math is you get a hardened denominator. That hardened denominator ensures that everyone (common stock and investors) shares pro-rata in post-closing capitalization changes, like future rounds and option pool changes. Everyone has appropriately-apportioned “skin in the game.” Another benefit of this hardened capitalization (denominator) is that it makes modeling the round easier. Wasn’t that what YC says they were trying to do with the Post-Money SAFE? Why not make modeling easier without hurting founders with harsher dilution?

So the “best of both worlds” solution is: do a convertible note or pre-money SAFE, but harden the denominator with the capitalization at the time of closing. You can even ensure it has an appropriately sized pool to account for expected equity grants until the next raise, much like you would in an equity round. Flexible numerator, but hardened denominator.

Making this change in a convertible note or SAFE is extremely easy. You simply delete all the language used for describing the denominator (the fully-diluted capitalization) and replace it with a number: your capitalization at the time of closing. Now both sides have the benefit of a valuation cap that adjusts if there is a “down round,” but a hardened denominator that allows everyone to model the expected dilution of the round; while ensuring that future dilution is shared proportionately between both founders and investors.

On top of being far more aligned with equity round economics (the default approach to fundraising), this approach can save common stockholders several percentage points on their cap table; a very high impact from just deleting a few words and replacing them with a number. When a seed equity raise won’t do, my recommendation is usually a low-interest, lengthy (2-3 yrs) maturity convertible note with a valuation cap and hardened denominator. As a lawyer who represents zero investors (all companies), I’ve felt that pre-money SAFEs are too company-biased, and post-money SAFEs are too investor-biased. SAFEs in general are also far less respected by investors outside of Silicon Valley than convertible notes are.

We’ve been explaining this issue to clients and investors and are happy to say that there has been a positive reception. We hope to see it utilized more broadly in the market over time. See: A Convertible Note Template for Startup Seed Rounds for a convertible note template that startups can utilize (with appropriate lawyers) for their seed rounds.

Do I expect all seed investors to adopt this approach? Of course not. They’re investors, and will naturally prefer something far more aggressive in their favor, like YC’s post-money SAFE. It all depends on context, character, and leverage. Nevertheless, founders should go into seed rounds with their eyes wide open about the significant economic implications of the various structures and formulas, and not give into any hot air about there being a single (air quotes) “standard” approach, when what investors are really promoting is their preferred “standard.”  Pushing misleading “standards” is a far-too-common negotiation tactic for getting inexperienced founders to mindlessly pursue financing strategies that are against their company’s interests.