2 weeks ago | posted a Twitter thread that went viral. Here was the lead into that thread:

‍

You might think the thread is just a list of complaints. It's not. 

To make sure people understood my point, I started with background/history and explained basic mechanics of a SAFE.

It spread because I explained a topic most founders don’t understand but are too ashamed to ask about. It doesn’t hurt that I exposed something insidious about SAFEs…

I converted the thread to more of an essay format. Enjoy!

The Danger of Post-Money SAFEs

I see hundreds of deals every year.

In the past 2 yrs, 99% of those deals under $3MM have been done on POST-money cap SAFEs. The crazy thing is 99% of founders don’t know how this fairly new fundraising instrument works.  

The worst part is that this ignorance comes with a major cost…

First a bit of history

In the beginning, people made their investments into startups via the direct purchase of equity. Companies would collect money and issue equity.  This is an involved process that requires extensive legal work.  And any time the words “extensive” and “legal” come together you know you’re talking about large amounts of time and money.

This made raising capital at the earliest stages of companies more complicated than necessary.

To address that, the convertible note was introduced. With this new format, companies could quickly raise money using a 2-3 page legal document.

Convertible notes were a debt agreement that would convert into equity when the company raised an equity round in the future.

The speed and relative simplicity of convertible notes were great, but they had annoying parts too. They were inconsistent between law firms and included elements of debt that didn't apply to startups.

Startups didn’t have any other options when it came to faster ways to raise capital so they lived with the pain.  The downsides were just a cost of doing business.

...until the SAFE arrived

SAFE stands for Simple Agreement for Future Equity

YC introduced the first SAFE in 2014 to great fanfare. Why? SAFEs represented a standardized, founder-friendly replacement to the convertible note (the old way startups raised money quickly).

SAFEs eliminated a lot of annoying features in convertible notes like interest and maturation dates. More importantly, YC pushed it to all 100+ graduating companies.  When the most sought after startup investments all use the same documentation, it effectively creates a standard. This standard did a lot for the broader startup community by eliminating lots of legal money and time wasted. It was a godsend to founders.

The first SAFE used PRE-money caps.

But what are “caps”? 

The cap is a number that determines the valuation used to calculate ownership for SAFE holders when it converts (in most cases).  

The exception is when a company raises an equity round at a valuation that is lower than the cap.  The details of that can be saved for another post because it happens so infrequently. 

Here is a spelled out example:

Let’s say you invest $1M into a company using a SAFE with a PRE-money cap of $9M.  If that company raises an equity round at anything above a $9M pre-money valuation, your $1MM investment would convert by purchasing $1M worth of shares at a price of $9M / [total # of shares].  It’s called a “cap” because even if the next equity round raises at $100M valuation, your conversion price is capped at the $9M.

The rush towards SAFEs

As the market kept heating up, founders increasingly favored raising on SAFEs over equity, across successive rounds & in larger round sizes.

• Pro: process was cheaper, quicker, & retained more control for founders
• Con: both founders & investors began losing track of ownership

The issue is SAFEs are not technically equity ownership until a "conversion event."

Even though the industry makes decisions assuming the conversion event will occur, founders & investors don't update cap tables and ownership levels accordingly.

They wait…

And when they wait for an equity raise to update ownership levels, they are surprised to see how much dilution has actually occurred.

I say "they" because that surprise hits both founders and investors.

Investors take issue with SAFEs

A common refrain for why the surprise was so severe is that the pre-$ cap made it hard to calculate ownership levels quickly especially when there were multiple SAFEs in play.

In other words, because It took a spreadsheet to calculate ownership, founders were getting burned.

The surprise for investors was slightly different. They also had trouble predicting their ownership but it wasn't because they couldn't work a spreadsheet.

Investors LIVE in spreadsheets so it wasn't that.

The issue was simpler: this new trend was hitting their pocketbooks😡💸

The speed of SAFEs made it so easy that founders were raising quickly & repeatedly. It wasn't uncommon for a founder to raise one SAFE & months later raise another SAFE.

Investors couldn't predict ownership b/c their investments were getting DILUTED by successive SAFEs.

These issues were enough to mobilize YC to make a huge change to the standard SAFE.

The move to Post-Money caps

In 2018, YC introduced the POST-money cap to its standard SAFE.

Without going into the mechanics (I'll save that for another post), the post-$ cap solved for those 2 issues of uncertainty.

First, founders no longer needed a complicated model to determine dilution across multiple SAFEs. With the new post-$ cap, simple arithmetic would suffice.

Take this simple example of raising money across 2 SAFEs...

If you raise $1M on a $10M post-$ cap, the dilution calculation is just 1/10 = 10%

and if you raise another $2M on a $20M post-$ cap, that's again 2/20 = 10% dilution

And to calculate total dilution? Now it's simple addition. 10% + 10% = 20%

Simple!

And for investors?

Well for investors, the reason that math above is so simple for founders is the post-$ cap SAFE now has anti-dilutive properties.

That first 10% remains 10% when you add the next round b/c no additional money raised on SAFEs before an equity round dilutes investor ownership.

Did you catch that?

For founders to get easier math, they are paying with percentage points of their company

In a world where SAFE stacking is a common strategy, it does feel slightly unfair to have an investment get diluted weeks after it is signed.

That said, there are also founders who spend months if not years between SAFEs. NOT diluting those investments feels even more unfair.

Let me spell this out...

In order to make dilution calculations easier, founders are giving investors anti-dilution and sacrificing percentages of their company by using post-$ SAFEs!

The Pre vs. Post-money cap math

For the nerds out there, the diagram below lays out the legal language + math that predicates the anti-dilutive properties of post-$ SAFEs

The important equation to remember is SAFE Amount / Safe Price = Note Shares.

Total sharecount (denominator in SAFE price calc) excludes all converting securities in pre-$ SAFE.

Post-money includes them.

So with more pre-money notes, the denominator remains unchanged, resulting in higher SAFE price. This equals fewer shares upon conversion (less dilution for founder)

Don't believe me? Check out the side by side comparison (I've chosen two scenarios with the same effective post-money valuations)

If you'd like to play around with the model yourself, check it out here-> https://docsend.com/view/59b7yb9i57kchiyz 

So to wrap up…

Are post-$ SAFEs always bad?  No. 

If you're only going to raise one SAFE before you raise equity, then it works well.

If you're precise with your planning and know what you're getting into, it's ok.

If you have no other choice than to use a post-money cap, then 🤷🏻

(these are all BIG ifs!)

The recap:

• Post-money cap SAFEs = easier to calculate
• Post-money cap SAFEs are not diluted until an equity round is raised
•  If you think you'll raise multiple SAFEs, strongly consider using a pre-$ cap (especially if spread out over time)
• No matter what instrument you use, update your expected ownership levels after each one you raise!

Recognition

My collaborator on this work was Jordan Pascasio from Next Ventures especially with the models and numbers.  Jordan’s a stud investor and also writes a great newsletter you should check out here -> https://jordanpascasio.substack.com/