10: safe agreements - avoid costly mistakes
Prior to SAFE’s, startups used convertible debt but this mode was undesired due to the debt instrument’s interest paying, complex negotiations and maturity of payment characteristics.
SAFEs (Simple Agreement for Future Equity) was created by YC in 2013 to develop an instrument that lets accredited investors invest in seed stage companies and do so in a manner that’s simple and founder friendly.
Still with this 2013 version, investors didn’t quite know what their ownership % would end up being.
2018 brought an update which is called the Post-money SAFE and one where exact ownership % is known. This is more investor friendly but can surprise founders with dilution.
Let’s see how a $1M investment for a $20M, 20% discount Series A pre-money valuation plays out under various scenarios
An additional scenario exists when a startup issues another SAFE to a new investor, assuming under the ‘no cap no discount’ scenario.
Assume the startup issues another SAFE with a $10M cap.
The Most Favored Nation (MFN) clause would allow the first investor to also adopt the $10M cap and in this case, the first investor would upgrade to a 10% ownership.
Now let’s explore a blind spot especially as it related to stacking SAFEs
Assume the startup raises $2M across 3 SAFE’s
Investor A ($500k at $5M cap)
Investor B ($1M at $10M cap)
Investor C ($500k at $15M cap)
Series A at $20M pre-money valuation
Since each SAFE converts to the lower of its cap or series A valuation,
Investor A converts at $5M -> 10% ownership
Investor B converts at $10M -> 10% ownership
Investor C converts at $15M -> 3.3% ownership
The startup just got diluted by 23.3% and the early investors got maximum benefit at lower caps.
This is different to one investment of $2M that would have come with 10% ownership ($20M aggregate cap across the 3 investors)
This scenario is the simplest to understand.
In practice, variants are often mixed and this can result in a very complex and messy cap table that has the startup founder losing out on significant amounts of equity.
It is therefore advisable that a founder connects with their financial advisor / consultant so that expensive mistakes can be avoided while founders do what they do best, build.
