By Eric Adler
Y Combinator’s shift from Pre-Money to Post-Money SAFEs added strong investor Anti-Dilution rights that cost many startups 7+ figures in long-term cap table value. This post (a) proposes a small edit to the SAFE to remove the anti-dilution feature, and (b) provides a spreadsheet comparing the economics between Pre-Money SAFEs, Post-Money SAFEs, and our new “Redlined” Post-Money SAFEs.
Post-Money SAFE Anti-Dilution
In 2013, YCombinator created the SAFE as a quick and founder-friendly alternative to convertible notes. They were great for startups, and very founder friendly. The math was a bit complicated, but you can build a spreadsheet to figure it out.
In 2018, YC gave us the Post-Money SAFE. YC boasted that it had a “huge advantage for both founders and investors - the ability to calculate immediately and precisely how much ownership of the company has been sold.” To figure out how much of the company you’re selling, you just divide the face value by the valuation cap. If you sell a $1M SAFE at a $10M valuation cap, you’ve sold 1/10th of the company. No spreadsheet needed. This is a good feature! But founders pay a very high price for this feature.
The reason we know precisely how much of the company the investor is buying is because the investor gets Full-Ratchet Anti-Dilution Protection at the expense of the founders. If there are future SAFE financings, whether up-round or down-round, then any dilution from the new rounds gets jammed into the founders side of the cap table.
Full-Ratchet Anti-Dilution is a lousy deal for founders. It can cost founders hundreds of thousands to millions of dollars in long term cap table value. As an explicitly negotiated term, about 0% of the deals I see include Full-Ratchet Anti-Dilution (let alone up round anti-dilution protection). Same goes for Fenwick, Cooley, and WSGR. If founders never agree to explicit Full-Ratchet Anti-Dilution, then they shouldn’t agree to implicit Full-Ratchet Anti-Dilution via Post-Money SAFEs.
For a deeper dive into the problems with YC’s post-money SAFE, and the broader problem with unquestioning reliance on templates from investors, see this post.
The Anti-Dilution Solution
With a small adjustment to the Post-Money SAFE, we can keep the easy math and jettison the Anti-Dilution. Investors still know exactly how much of the company they are buying in the CURRENT SAFE round; much like they would if it were an equity round. However, the dilution from any future SAFE rounds will be shared evenly, not concentrated on the founders.
Here’s the edit to the Post-Money SAFE language, with new language in red:
“Company Capitalization” is calculated as of immediately prior to the Equity Financing and (without double-counting, in each case calculated on an as-converted to Common Stock basis):
- Includes all shares of Capital Stock issued and outstanding;
- Includes all Converting Securities outstanding as of the final closing of the SAFE financing in which this SAFE is issued, but expressly excludes subsequently issued Converting Securities with different valuation caps;
- Includes all (i) issued and outstanding Options and (ii) Promised Options; and
- Includes the Unissued Option Pool, except that any increase to the Unissued Option Pool in connection with the Equity Financing shall only be included to the extent that the number of Promised Options exceeds the Unissued Option Pool prior to such increase.
My colleague Jose Ancer proposed this change and wrote a thoughtful blog post on it here.
You and your lawyer could adjust the language further. For example, you could provide that “up round” convertibles (higher valuation caps) dilute everyone, but down-round (lower valuation cap) convertibles don’t dilute the investors.
How The Amendment Affects Your Cap Table Math
This spreadsheet shows how the math works for Pre-Money, Post-Money and the proposed amendment we’re calling “Redlined Post-Money” SAFEs. You can copy the sheet and plug in your own numbers.
For the default terms, I picked a middle-of-the-market example (with two SAFE rounds followed by a Series A). In this example, founders are giving up $900k in “Series A dollars” (cap table value as of Series A closing) by agreeing to a Post-Money SAFE. This would easily be 7-figures, potentially 8-figures, in an exit. If you can negotiate for the Redlined Post-Money SAFE (vs the normal Post-Money SAFE), you earn the founders about $1.2M at the close of the Series A, and with a high-growth trajectory you could be saving 5-10x that in an exit.
It’s worth pausing to emphasize this: YC’s shift from pre-money to Post-Money SAFEs is costing many startups 7+ figures in long-term cap table value; and “fixing” this can be just a matter of adding a few extra words.
Some takeaways from the spreadsheet:
- To compare Pre- vs. Post-Money valuation caps, be sure to increase the Post-Money Cap by the amount of money raised in the round. If you’re raising $1M on SAFEs, then a $5M Pre-Money Cap is like a $6M Post-Money Cap. This is built in to the spreadsheet.
- If you only raise one SAFE round, the Post-Money SAFEs can be better for founders. The reason is that Post-Money SAFEs do not include the stock plan increase in the denominator of their “Price per share” conversion math. In the spreadsheet, try setting the size of the second SAFE round to zero (D21), and then adjust the size of the stock plan increase up and down (D9).
- If a startup raises multiple SAFE rounds, the Post-Money SAFE becomes a much worse deal for founders (as compared to a Pre-Money SAFE or Redlined Post-Money SAFE).
Digging Deeper Into the SAFE Cap Table Math
Starting from the basics: the principal dollar amount of a SAFE will convert into some number of shares in a future Series A round. The SAFE dollars convert into Series A shares at a conversion price. For example, if an investor has a $1,000 SAFE and the conversion price is $2/share, she gets 500 Series A shares.
What is the conversion price? It’s a ratio where the numerator is the SAFE valuation cap, and the denominator is some number of shares that roughly represents the size of the company. The shares we include or exclude from this denominator will change the conversion price.
- The more shares that we dump into the denominator bucket, the lower the SAFE conversion price.
- The lower the SAFE conversion price, the more SAFE conversion shares the investor receives in the Series A.
In the standard Post-Money SAFE, the SAFE conversion shares are included in the Denominator. (This is circular, as the SAFE conversion shares are both the output of our math and also part of the input. Google sheets doesn’t blink at this.) Since the SAFE conversion shares are part of the denominator, this means the more SAFEs you sell, the bigger the Denominator becomes. As I mentioned above, a bigger denominator means a lower Conversion price, and a lower conversion price means more shares for the investor and more dilution for the founders.
In the new math of the Redlined Post-Money SAFE, the SAFE conversion shares from the current SAFE round are included in the Denominator. This makes it easy to calculate how much of the company you are selling with each SAFE. But SAFE conversion shares from future SAFE rounds are not included in the Denominator. This removes the Full Ratchet Anti-Dilution protection.
What If My Startup Has Already Issued a Post-Money SAFE?
It’s not terrible. However, it is a big incentive to structure your next financing as an equity round (converting your post-money SAFEs) rather than doing another SAFE round (which will heavily dilute founders).
You have three options for your SAFEs.
- Pre-Money SAFE. Founder-favorable economics. The cap table math is difficult to do in your head. Spreadsheet required.
- Post-Money SAFE. Cap table math is easy, but investors get Full-Ratchet Up/Down Anti-dilution on future SAFE rounds.
- Redlined Post-Money SAFE. Cap table math is easy, and no Anti-dilution for future SAFE rounds.
The YC Post-Money SAFEs are not inherently bad. YC provides real value and has a lot of bargaining power. They can negotiate for off-market terms like full-ratchet anti-dilution protection. However, if YC is going to stick founders with off-market terms, they should be explicit about it.
And if you’re a founder with bargaining power, then you shouldn’t let investors sneak in an anti-dilution provision.
Thanks to Jose Ancer for his input on this post and the spreadsheet.