The (Big) Problem with Post-Money SAFEs

While Y Combinator’s SAFE (Simple Agreement for Future Equity) has become a dominant form of seed round instrument in Silicon Valley, it remains a minority instrument in virtually every other ecosystem, including the Pacific Northwest. That’s one reason why it’s important to understand the context of any advice you read on the web, because a lot of startup legal advice is heavily California / Silicon Valley-centric. Using Silicon Valley guidance for non-Silicon Valley deals can get you into trouble because of different investor expectations and company needs.

The original YC SAFE had a pre-money calculation for its valuation cap, which is in line with how typical convertible notes work. The original SAFE was basically a convertible note with no interest or maturity date; almost everything else was exactly the same as a typical convertible note we’d see utilized for seed funding.

Many investors in ecosystems outside of Silicon Valley objected to SAFEs (the original pre-money ones) as being too company friendly, even egregiously so. We don’t necessarily disagree with them, and that’s saying something because at E/N, we don’t represent tech investors. We’re company focused, to avoid conflicts of interest. If you want to know why, maybe read Relationships and Power in Startup Ecosystems.

There is a point at which the terms you expect of investors are too one-sided, and you start to lose credibility; signaling that you are trying to intentionally avoid any kind of reasonable accountability. Don’t cross that line, even if pockets of Silicon Valley (often due to the unique and abnormal amount of competition among investors) have normalized it in their world.

Recently, YC updated their SAFEs and did a complete 180, making SAFEs far more investor favorable. The new SAFE has a post-money calculation for its valuation cap, which dramatically changes how the economics work. The most dangerous part about the new Post-Money SAFE is that your investors get essentially full anti-dilution protection for all convertible rounds (notes or SAFEs) that you do after closing the first SAFE round, until an equity round (conversion event) occurs. Founders and employees would eat all of that dilution, whereas if another conventional structure was used (including Pre-Money SAFEs and convertible notes), dilution would be shared across the cap table.

Lots of companies raise multiple seed rounds and are unable to predict when they’ll hit the right milestones to do an equity round. The full anti-dilution protection in Post-Money SAFEs can get really out of hand, and give away a lot more of the cap table to investors, in those contexts.

The argument that YC makes for why they made this change is that a post-money cap makes modeling SAFEs in a capitalization model easier. That may be true, but they neglect to mention that there are plenty of other ways to make modeling convertible notes or SAFEs easier without making economics so unfavorable for founders and other common stockholders. The easiest example is “hardening” the denominator used for calculating the conversion price. Another is just doing a simple seed equity round, with documents that are simpler and cheaper to draft than a full VC-style equity round.

The main takeaway for founders in the Pacific Northwest is to understand that Post-Money SAFEs are a way different economic proposition than the original SAFEs, and extreme caution is warranted. From what we’ve seen, the original SAFEs were already a minority instrument outside of Silicon Valley, even when they were super company friendly. With the much harsher terms, we expect the new SAFEs to be used even less often. There are better, more balanced options already known and available.

For a deeper dive into this topic, see Why Startups Shouldn’t Use YC’s Post-Money SAFE.

Update 12-8-2021: This new post suggests an easy amendment you can make to the Post-Money SAFE to remove the Anti-Dilution.