Post Category → SAFEs

“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.

Why Startups shouldn’t use YC’s Post-Money SAFE

TL;DR: If you’re going to use it, you should make some slight (but material) tweaks. It otherwise gives your seed investors a level of extreme anti-dilution protection that is virtually unheard of (circa 2019) in startup finance, making it worse than seed equity and conventional convertible notes (or pre-money SAFEs) in terms of economics for most seed stage companies; which is of course why investors love it. There are far better, more balanced ways to “clarify” ownership for seed investors without forcing founders and employees to absorb additional dilution risk. YC has done a “180” in moving from the pre-money SAFE (very company friendly) to the post-money SAFE (extremely seed investor friendly).

Post-Publishing Updates:

A regular underlying theme you’ll read on SHL is that key players in the startup community are incredibly talented at taking a viewpoint that is clearly (to experienced players) investor-biased, but spinning / marketing it as somehow “startup friendly.”  And lawyers captive to the interests of investors are always happy to play along, knowing that inexperienced teams can be easily duped.

One example is how “moving fast” in startup financing negotiations is always a good thing for entrepreneurs. Investors are diversified, wealthy, and 100x as experienced as founders in deal terms and economics, but it’s somehow in the founders’ interest to sign whatever template the investor puts on the table, instead of actually reviewing, negotiating, and processing the long-term implications? Right.

Y Combinator’s move to have its SAFEs convert on a post-money, instead of pre-money, basis is another great example. Their argument is that it helps “clarify” how the SAFEs will convert on the cap table. Clarity is great, right? Who can argue with clarity?

What’s not emphasized prominently enough is that the way they delivered that “clarity” is by implementing anti-dilution protection for SAFE investors (like themselves) that is more aggressive than anything remotely “standard” in the industry; and that wasn’t necessary at all to provide “clarity.” Under YC’s new SAFE, the common stock absorbs all dilution from any subsequent SAFE or convertible note rounds until an equity round, while SAFE holders are fully protected from that dilution. That is crazy. It’s the equivalent of “full ratchet” anti-dilution, which has become almost non-existent in startup finance because of how company unfriendly it is. In fact, it’s worse than full ratchet because in a typical anti-dilution context it only triggers if the valuation is lower. In this case, SAFE holders get fully protected for convertible dilution even if the valuation cap is higher. It’s a cap table grab that in a significant number of contexts won’t be made up for by other more minor changes to the SAFE (around pro-rata rights and option pool treatment) if a company ends up doing multiple convertible rounds.

When you’re raising your initial seed money, you have absolutely no idea what the future might hold. The notion that you can predict at your initial SAFE closing whether you’ll be able to raise an equity round as your next funding (in order to convert your SAFEs), or instead need another convertible round (in which case your SAFE holders are fully protected from dilution), is absurd. Honest advisors and investors will admit it. Given the dynamics of most seed stage startups, YC’s post-money SAFE therefore offers the worst economics (for companies) of all seed funding structures. Founders should instead opt for a structure that doesn’t penalize them, with dilution, for being unable to predict the future.

Yes, YC’s original (pre-money) SAFE has contributed to a problem for many SAFE investors, but that problem is the result of an imbalanced lack of accountability in the original SAFE structure; not a need to re-do conversion economics. As mentioned in the above TechCrunch article, the reason convertible notes are still the dominant convertible seed instrument across the country is that the maturity date in a convertible note serves as a valuable “accountability” mechanism in a seed financing. A 2-3 year maturity gives founders a sense of urgency to get to a conversion event, or at least stay in communication with investors about their financing plans. By eliminating maturity, SAFEs enabled a culture of runaway serial seed financings constantly delaying conversion, creating significant uncertainty for seed investors.

YC now wants to “fix” the problem they themselves enabled, but the “solution” goes too far in the opposite direction by requiring the common stock (founders and early employees) to absorb an inordinate amount of dilution risk. If “clarity” around conversion economics is really the concern of seed investors, there are already several far more balanced options for delivering that clarity:

Seed Equity – Series Seed templates already exist that are dramatically more streamlined than full Series A docs, but solidify ownership for seed investors on Day 1, with normal weighted average (not full ratchet) anti-dilution. 100% clarity on ownership. Closing a seed equity deal is usually a quarter to a third of the cost of a Series A, because the docs are simpler. Seed equity is an under-appreciated way to align the common stock and seed investors in terms of post-funding dilution. Yes, it takes a bit more time than just signing a template SAFE, but it’s an increasingly popular option both among entrepreneurs (because it reduces dilution) and investors (because it provides certainty); and for good reason.

See also: Myths and Lies about Seed Equity to better understand the false arguments often made by investors to push founders away from seed equity as a financing structure.

Harden the denominator – Another option I’ve mentioned before in Why Notes and SAFEs are Extra Dilutive is to simply “harden” the denominator (the capitalization) that will be used for conversion on Day 1, while letting the valuation float (typically capped). This ensures everyone (common and investors) are diluted by subsequent investors, just like an equity round, while allowing you to easily model conversion at a valuation cap from Day 1. If the real motivation for the SAFE changes was in fact the ability to more easily model SAFE ownership on the cap table – instead of shifting economics in favor of investors – this (hardening the conversion denominator) would’ve been a far more logical approach than building significant anti-dilution mechanisms into the valuation cap.

See “Fixing” Convertible Note and SAFE Economics for a better understanding of how hardening the denominator in a note or SAFE valuation cap gives the “best of both worlds” between convertibles and equity rounds.

Add a Maturity Date – Again, the reason why, outside of Silicon Valley, so many seed investors balk at the SAFE structure altogether is because of the complete lack of accountability mechanisms it contains. No voting rights or board seat. No maturity date. Just hand over your money, and hope for the best. I don’t represent a single tech investor – all companies – and yet I agree that SAFEs created more problems than they solved. Convertible notes with reasonable maturity dates (2-3 years) are a simple way for investors and entrepreneurs to get aligned on seed fundraising plans, and if after an initial seed round the company needs to raise a second seed and extend maturity, it forces a valuable conversation with investors so everyone can get aligned.

Conventional convertible notes – which are far more of an (air quotes) “standard” across the country than any SAFE structure – don’t protect the noteholders from all dilution that happens before an equity round. That leaves flexibility for additional note fundraising (which very often happens, at improved valuations) before maturity, with the noteholders sharing in that dilution. If a client asks me whether they should take a low-interest capped convertible note with a 3-yr maturity v. a capped Post-Money SAFE for their first seed raise, my answer will be the convertible note. Every time, unless they are somehow 100% positive that their next raise is an equity round. The legal fees will be virtually identical.

Before anyone even tries to argue that signing YC’s template is nevertheless worth it because otherwise money is “wasted” on legal fees, let’s be crystal clear: the economics of the post-money SAFE can end up so bad for a startup that a material % of the cap table worth as much as 7-figures can shift over to the seed investors (relative to a different structure) if the company ends up doing additional convertible rounds after its original SAFE; which very often happens. Do the math.

The whole “you should mindlessly sign this template or OMG the legal fees!” argument is just one more example of the sleight-of-hand rhetoric peddled by very clever investors to dupe founders into penny wise, pound foolish decisions that end up lining an investor’s pocket. It can take only a few sentences, or even the deletion of a handful of words, to make the economics of a seed instrument more balanced. Smart entrepreneurs understand that experienced advisors can be extremely valuable (and efficient) “equalizers” in these sorts of negotiations.

When I first reviewed the new post-money SAFE, my reaction was: what on earth is YC doing? I had a similar reaction to YC’s so-called “Standard” Series A Term Sheet, which itself is far more investor friendly than the marketing conveys and should be rejected by entrepreneurs. Ironically, YC’s changes to the SAFE were purportedly driven by the need for “clarity,” and yet their recently released Series A term sheet leaves enormous control points vague and prone to gaming post-term sheet; providing far less clarity than a typical term sheet. The extra “clarity” in the Post-Money SAFE favors investors. The vagueness in the YC Series A term sheet also favors investors. I guess YC’s preference for clarity or vagueness rests on whether it benefits the money. Surprised? Entrepreneurs and employees (common stockholders) are going to get hurt by continuing to let investors unilaterally set their own so-called “standards.”

One might argue that YC’s shift (as an accelerator and investor) from overly founder-biased to overly investor-biased docs parallels the natural pricing progression of a company that initially needed to subsidize adoption, but has now achieved market leverage. Low-ball pricing early to get traction (be very founder friendly), but once you’ve got the brand and market dominance, ratchet it up (bring in the hard terms). Tread carefully.  Getting startups hooked on a very friendly instrument, and then switching it out mid-stream with a similarly named version that now favors their investors (without fully explaining the implications), looks potentially like a clever long-term bait-and-switch plan for ultimately making the money more money.

YC is more than entitled to significantly change the economics of their own investments. But their clear attempts at universalizing their preferences by suggesting that entrepreneurs everywhere, including in extremely different contexts, adopt their template documents will lead to a lot of damaged startups if honest and independent advisors don’t push back. The old pre-money SAFE was so startup friendly from a control standpoint that many investors (particularly those outside of California) refused to sign one. The new post-money SAFE is at the opposite extreme in terms of economics, and deserves to be treated as a niche security utilized only when more balanced structures won’t work. Thankfully, outside of pockets of Silicon Valley with overly loud microphones, the vast majority of startup ecosystems and investors don’t view SAFEs as the only viable structure for closing a seed round; not even close.

The most important thing any startup team needs to understand for seed fundraising is that a fully “standard” approach does not exist, and will not exist so long as entrepreneurs and investors continue to carry different priorities, and companies continue to operate in different contexts. Certainly a number of prominent investor voices want to suggest that a standard exists, and conveniently, it’s a standard they drafted; but it’s really just one option among many, all of which should be treated as flexibly negotiable for the context.

Another important lesson is that “founder friendliness” (or at least the appearance of it) in startup ecosystems is a business development strategy for investors to get deal flow, and it by no means eliminates the misaligned incentives of investors (including accelerators). At your exit, there are one of two pockets the money can go into: the common stock or the investors. No amount of “friendliness” changes the fact that every cap table adds up to 100%. Treat the fundraising advice of investors – even the really super nice, helpful, “founder friendly,” “give first,” “mission driven,” “we’re not really here for the money” ones – accordingly. The most clever way to win a zero-sum game is to convince the most naive players that it’s not a zero-sum game.

Don’t get me wrong, “friendly” investors are great. I like them way more than the hard-driving vultures of yesteryear. But let’s not drink so much kool-aid that we forget they are, still, investors who are here to make money that could otherwise go to the common stock; not your BFFs, and certainly not philanthropists to your entrepreneurial dreams.

Given the significant imbalance of experience between repeat money players and first-time entrepreneurs, the startup world presents endless opportunities for investors (including accelerators) to pretend that their advice is startup-friendly and selfless – and use smoke-and-mirrors marketing to convey as much – while experienced, independent experts can see what is really happening. See Relationships and Power in Startup Ecosystems for a deeper discussion about how aggressive investors in various markets gain leverage over key advisors to startups, including law firms, to inappropriately sway negotiations and “standards” in their favor.

A quick “spin” translation guide for startups navigating seed funding:

“You should close this deal fast, or you might lose momentum.” = “Don’t negotiate or question this template I created. I know what’s good for you.”

“Let’s not ‘waste’ money on lawyers for this ‘standard’ deal.”  = “Don’t spend time and money with independent, highly experienced advisors who can explain all these high-stakes terms and potentially save a large portion of your cap table worth an order of magnitude more than the fees you spend. I’d prefer that money go to me.”

“We’re ‘founder friendly’ investors, and were even entrepreneurs ourselves once.” = “We’ve realized that in a competitive funding market, being ‘nice’ is the best way to get more deal flow. It helps us make more money. Just like Post-Money SAFEs.”

“Let’s use a Post-Money SAFE. It helps ‘clarify’ the cap table for everyone.” = “Let’s use a seed structure that is worse for the common stock economically in the most important way, but at least it’ll make modeling in a spreadsheet easier. Don’t bother exploring alternatives that can also ‘clarify’ the cap table without the terrible economics.”

There are pluses and minuses to each seed financing structure, and the right one depends significantly on context. Work with experienced advisors who understand the ins and outs of all the structures, and how they can be flexibly modified if needed. In the case of startup lawyers specifically, avoid firms that are really shills for your investors, or who take a cookie-cutter approach to startup law and financing, so you can trust that their advice really represents your company’s best interests. That’s the only way you can ensure no one is using your inexperience – or fabricating an exaggerated sense of urgency or standardization – to take advantage of you and your cap table.

How LLC Startups Raise Money

TL;DR: Very similarly to how “classic” C-Corp startups do, with a few important caveats.

Background Reading:

As I’ve written a few times before, the trend of entrepreneurs (somewhat) mindlessly accepting the advice – that forming their companies and raising investment should always be as standardized as clicking a few buttons – appears to be reversing, at least outside of Silicon Valley. This trend is very much related to all the public stories from experienced founders emphasizing the downsides of following a “standard” path, taking on “standard” VC investment with very high-growth expectations, and how it can cut off a lot of more nuanced/appropriate growth and fundraising strategies. For more on that, see: Not Building a Unicorn. 

As entrepreneurs are spending more time exploring all their options, LLCs are increasingly popping up. I’ve written before about when an LLC may make sense for a startup (C-Corps are still by far the dominant structure). It generally boils down to whether the founder team thinks there’s a possibility that, instead of constantly reinvesting earnings for growth and looking for an exit, they’ll decide to let the business become profitable and distribute dividends to investors. C-Corps are very tax inefficient for those kinds of companies.

So naturally as LLCs become part of the discussion, the next question is how LLC startups can raise investment. Some founders have been incorrectly advised that LLC startups simply don’t raise investment at all. They think that C-Corp = investment, and LLC = run on revenue. That’s far from the case. While true that institutional tech VCs very often won’t invest in LLCs (although that too is changing), the pool of investors interested in early-stage tech companies is much more diverse now than it was even five years ago. Lots of strategic investors, angels, and investors from other industries looking at tech are quite comfortable investing in LLCs, and do so all the time.

LLC startup fundraising looks, at a high level, a lot like C-Corp fundraising.

Capital Interests – Units, Membership Interests, Capital Interests. These are all synonyms for the LLC equivalent of stock. The documentation for these types of investments looks very different from a C-Corp preferred stock financing only because the underlying organizational docs of LLCs are different: you don’t have a “Certificate of Incorporation,” as an example, you have an LLC Operating Agreement.  But the core rights/provisions often end up very similar. A liquidation preference giving the investors a right to get their money back before the common – often see “Common Units” for founders/inside people and “Preferred Units” for investors. Voting provisions re: who gets to elect the Board of Managers (LLC equivalent of a Board of Directors), and other similar rights.

Convertible Notes – These look 95% like C-Corp convertible notes, including with discounts/valuation caps to reward early-stage risk, just drafted a bit more flexibly to account for whether the notes convert into LLC equity or C-Corp equity (if the company decides to become a C-Corp).

SAFEs – Yes, there are LLCs now doing SAFEs, although the SAFE instrument requires tweaking (like convertible notes) to make sense for an LLC. Even for C-Corps, we still see SAFEs being used only in a limited number of cases (again, because we serve companies outside of California, where SAFEs dominate). That’s because they are about as company favorable (and investor unfavorable) as you can get, and many investors balk at what they see as an imbalance. LLC SAFEs are even rarer than C-Corp SAFEs, but they do come up.

LLCs are known for their flexibility, and given that LLC companies tend to be more “cash cow” oriented than C-Corps, even more alternative financing structures are popping up: royalty-based investment is one example, where investors take a % of revenue as a way to earn their return, instead of expecting it in the form of a large exit or dividend. But those are still so uncommon (for now at least) that they’re not worth digging further into.

As I’ve repeated several times before, the big issue with LLCs and fundraising is you absolutely need a tax partner involved. By that, I mean a senior lawyer with deep experience in the tax implications of LLC structures and investment. This is not a “startup lawyer,” but a very different specialty. The flexibility of LLCs brings with it significant tax complexity at the entity and individual holder level, and even the brightest corporate lawyers are not qualified to handle that on their own. 

The majority of emerging tech companies still end up as C-Corps, simply because it still makes sense for the type of business they plan to build. But even with C-Corp land, founders are digging much deeper into how to structure and fundraise for their companies, and pushing back on the suggestion that they should just sign some templates and move on; as if what the templates say (and don’t say) doesn’t really matter.  That may still work for the “billion or bust” high growth mentality of unicorns, but entrepreneurs who feel they’re building something different want flexibility, and to understand the full scope of options.