TBC: Unpacking Uncapped SAFEs

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Everyone welcome to another episode of the back channel.

In the last episode, I started wading into the waters of valuation gaps. My comment was that. Valuation cap is a term that many founders throw out there. They even negotiate around valuation caps. many founders, especially first time founders don't have a really great understanding of what valuation caps are, how they work, how they convert, And that means that founders aren't really as sophisticated as they can be when they jump into the negotiating. End of the table with investors and they don't know how to control the situation. So after that episode, I thought we did a pretty good [00:01:00] job of laying out how the math works, what the valuation caps are there for. And it brought up a, another thought that I had, which was the idea of uncapped, safes, or uncapped notes. It turns out that I had written an essay about uncapped safes a while back.

And that continues to be the most popular essay that I've ever written on my blog. And so people are obviously very fascinated by this idea of an uncapped safe. I wanted to break down what an uncapped safe is. Y founders are excited about it. Why investors might not be excited about it? I'll talk a little bit about when I think uncap safes are worth using and when they're not. and then you guys can react to let me know if there are other topics around the idea of uncap safes. That you would like me to discuss.

So. What's an uncapped safe. I'll reference some of the stuff that I talked about last time around what a valuation cap is, but evaluation cap is [00:02:00] essentially the valuation that an investor is expecting to convert their money at. Remember when you're investing in a safe, you're not actually buying equity, you are getting a simple agreement for future equity.

So when you put a million dollars in at a $10 million evaluation cap, This is not a conversion into a bit of equity immediately. In the future, when that company raises an equity round, your money will convert at those terms. And that's where the valuation cap comes in. Now. When there isn't a cap when it's an uncapped safe. What's happening here. In an uncapped safe. There's usually a discount associated with the safe, a percentage discount as opposed to evaluation cap. So instead of saying, well, in the future, my million dollars will convert at a $10 million valuation for the company. Instead, if you say, well, there's no cap. but to [00:03:00] reward you for investing and taking on the risk, we will give you a 20% discount into the next round. What that means is let's say today. I'm not sure what the valuation of the company should be. But, you know, we think it's somewhere around $10 million. We don't know what that's going to be, But if a founder convinces an investor to invest in an uncapped safe, With a 20% discount. They could say, look, I'm about to raise money.

We think it will be at a $20 million evaluation. So in this case with an uncapped safe and a 20% discount, if the company then went on to raise. An equity round. At a $20 million valuation, your million dollars. Would come in at 20% lower than that $20 million. Meaning $16 million. So you were rewarded by investing a little bit earlier with that 20% discount. Now. It can [00:04:00] seem like this is a very easy trade-off like, yes, look. I don't really know what the valuation is.

I don't want to set the valuation right now. Let's instead just put a discount. That can seem like it makes sense. It's like, look, we're going to raise money. We don't know what it is. You might as well just take the discounts. It'll be easier on everyone.

Now, this can seem like it makes sense, but I can tell you based on my time at Greycroft, where we were burnt by uncapped notes and safes, that it's not great for investors in a lot of cases.

So what are the situations that end up burning investors? Well an uncapped safe with a discount will work if. The company ends up raising capital fairly shortly after. The investors come in on the uncap safes Because at that point then, well, That discount will. will accurately reflect the amount of additional risk that they took on by coming in a little bit early.

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But what I've seen happen is companies raise a large amount on an uncapped, safe, or bring in multiple investors on multiple uncapped safes continuing to add more and more dollars. So you thought as an investor, you were bridging them to a fundraise that would happen in a short period of time. A million dollars and that 20% discount. Would end up. Accurately reflecting how much you thought the company was worth. But what can happen is if you think you're investing in a company that, you know, we're somewhere between 10 and $20 million, but you didn't know, you don't know exactly where that is. And you would invest in this uncapped safe with a 20% discount.

What can happen is that company might end up raising more capital. Or that company might end up just being much more [00:07:00] capital efficient. And what happens then if the company goes. A year without raising maybe two years without raising and make a ton of progress on that money that you invested. And while you thought that the company was worth somewhere between 10 and $20 million, when they finally go out to raise capital. With an equity round, they get priced at a hundred million dollars. Which is incredible. Except your money. Would then convert in at the 20% discount at an $80 million valuation.

So you had an invested. Two years prior to this a hundred million dollar round, but you were only being rewarded by having your money convert in at an $80 million valuation. When back in the day, a year or two prior. Everyone thought that the company was worth something more like 10 to $20 million. So in my opinion, I don't think uncapped safes are a very good way to raise capital.

I don't think, it's good for. Investors. [00:08:00] Certainly, I don't think it's generally good for founders either. It's just an unclean lazy way of taking in capital. I would much rather founders and investors go through the additional effort. Of negotiating a real valuation cap. Don't take the lazy route of just saying an uncapped safe so that everyone has a clear understanding of where they stand. Now look, there are certain situations where an uncap safe may work. If you actually are. Raising around that is a bridge. To another raise that is definitely happening very soon. Then if we all agree that that's, what's going to happen, the uncapped safe can work well. I think those situations are few and far between.

And even in those situations, you can go ahead and negotiate a specific valuation Cap. But if you had to tell me. Gun to my head. What's a situation that you would use an uncapped safe. It would be that it would be a bridge to an equity round that we [00:09:00] know is going to happen. Very shortly. Okay. Now that you know why I don't like uncapped safes. Maybe you can go navigate the waters on your own and make your own decisions on whether or not that's something you'll want to bring up with an investor in the future. Okay. I hope you've enjoyed this episode of the back channel and I'll see you next time.

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