This article was originally published on TechCrunch as part of an ongoing series from industry experts, covering hot topics that founders are wrestling with every day as they build their companies.
With Y Combinatorʼs Demo Day taking place at Pier 48 in San Francisco this week, its largest batch of companies ever is getting ready to present to an audience of select investors. Having taken Atrium through Demo Day myself, I have first-hand knowledge of the process. When the founders have finished their pitches, the time to talk numbers will closely follow. Chief among the many decisions founders will face during this time is whether to opt for the Pre-Money SAFE or the new Post-Money SAFE, the two standardized legal documents that YC has introduced in recent years.
Both versions are meant to make the process fast, easy and fair for both parties in the early-stage fundraising process. But there are crucial differences between the two that founders should examine carefully.
Essentially, the Pre-Money SAFE is exceptionally favorable to founders because it gets them pre-valuation funding like a convertible note, but debt-free. The Post-Money SAFE sweetens some of the terms for investors, like locking in their percentage ownership in a priced round later on.
Overall, we expect the Post-Money version to become more common, especially if the company is raising a round above $1 million or $2 million, and the investors have more leverage to ask for it in the negotiation.
(Note: This article is aimed at giving founders a general understanding of the changes from Pre-Money SAFEs to Post-Money SAFEs. The information provided is based on my professional experience and opinions, and should not be used without careful consideration and advice by qualified advisors and legal counsel.)
Two Structures for Raising Startup Investment
Today there are two general ways of structuring a startup fundraising round. The first can be called a “priced equity round”, and is characterized by the sale of preferred stock with a fixed valuation. Priced equity rounds provide investors with the most robust rights, and are usually demanded by investors when large amounts of capital are being offered. The rounds often take 4-6 weeks to complete, require significant time from the management team, and can easily cost the company over $50,000 in legal fees, alone.
The second way of structuring a fundraising round can be called a “convertible round”, and is characterized by the sale of securities that convert into shares of preferred stock, once a subsequent priced equity round is led. One security that’s widely used in the US during convertible rounds is the convertible note. These agreements can easily be negotiated and prepared in less than one week, and often require less than 20% of the legal fees accumulated in a priced equity round. Another security that is now widely used during convertible rounds is what’s known as a SAFE, i.e. a Simple Agreement for Future Equity.
A Short History of SAFEs
Although issuing convertible notes is faster and cheaper than issuing priced equity, convertible notes are in fact a debt instrument, which means they must have an agreed maturity date (typically the date at which the noteholders may call the principal and interest due, or demand conversion into stock) and a statutory minimum interest rate — so there is still some major downsides with these documents. In order to eliminate much of the friction experienced by startups when raising capital on convertible notes, Y Combinator introduced the Pre-Money SAFE in 2013. The instrument is not technically classified as debt, and therefore works around the maturity date and interest requirements of convertible notes. The Pre-Money SAFE is standardized on a pre-money valuation, and has been widely adopted by the startup community, especially in Silicon Valley, for three primary reasons: (i) the overall terms are highly standardized, which further reduces transactions costs, (ii) there is no interest payable to investors, and (iii) there is no maturity date, which means the startup can basically ignore the SAFE until they raise a priced equity round.
Some changes have happened in the startup world since Y Combinator introduced the Pre-Money SAFE in 2013, however; namely, the increase in the overall size and volume of convertible rounds by individual startups. It’s become easier for startups to raise a large amount of capital in multiple convertible financing rounds as the investor community has become more comfortable with these instruments, and more early-stage capital has flooded into the market.
As companies continued raising more convertible rounds, Y Combinator saw that founders and early investors were having difficulty keeping track of their relative ownership stakes with each added investor and subsequent round. To alleviate that complexity, and make some additional technical changes to the document, the Post-Money SAFE was introduced in September 2018.
The primary purpose of this article is to compare the Pre-Money SAFE and Post-Money SAFE and provide general recommendations for when to use each document.
Key Changes in the Post-Money SAFE
Easier to Track Ownership and Dilution
With Pre-Money SAFEs, in order to valuate ownership and dilution, you must take into account the theoretical increase of shares to the company option pool during a subsequent equity round. This means the ownership and dilution values are more of an informed estimation, rather than a sure calculation. This can lead to uncertainty and confusion for all shareholders, including founders, early employees, and investors.
With Post-Money SAFEs, in order to valuate ownership and dilution, you remove the theoretical increase of shares to the company option pool from the equation and instead take into account the convertible securities (principally, SAFEs and convertible notes) issued by the company. Fundamentally what you are doing here is calculating the price per share at which the SAFE investor’s money converts. It is a simple division problem: Valuation Cap divided by Company Capitalization. By including converting securities in the definition of Post-Money Company Capitalization (they are excluded in Pre-Money definition), the denominator in that simple division problem is made larger. The larger the denominator, the lower the quotient, i.e., price per share. The lower the price per share, the more shares the SAFE investor gets for her money. The more shares they get, the more dilution suffered by other shareholders. This change to the price per share calculation is a bit technical (see YC’s primer for more details on the calculations) but the practical implication is that by using the Post-Money SAFE’s valuation standard you can quickly and precisely understand exactly how much of the company you have sold to each SAFE holder. However, a major drawback is that holders of Post-Money SAFEs will NOT participate in any dilution of subsequent financing rounds until the Post-Money SAFE converts at a priced equity round. Because that dilution must go somewhere, it is borne by the founders and early employees. With this component in mind, alone, it would seem that any Post-Money SAFE investor is getting a better deal than non-Post-Money SAFE holders on the cap table. However the proposed tradeoff is the increased clarity of ownership and future dilution — thought to promote more investor confidence (and thus more capital invested), while also allowing founders to have a more accurate account of their own ownership percentage, which helps when setting themselves up in a favorable position for subsequent rounds. More on these considerations below.
Share Dilution Breakdown
Pre-investment shareholders (founders, early employees, advisors, etc.)
- Pre-Money SAFE: Bear dilution from all subsequent investors.
- Post-Money SAFE: Bear dilution from all subsequent investors AND the dilution that would normally be borne by early investors if the company raises a convertible round following a Post-Money SAFE round.
Early stage investors
- Pre-Money SAFE: Bear dilution from all subsequent investment rounds regardless of format, i.e., SAFE, convertible notes, or priced round.
- Post-Money SAFE: Bear NO dilution by subsequent investment rounds, until it is an equity round. Many companies today are doing multiple convertible rounds before their priced round, so this can present an issue for early team members if the company starts with a Post-Money SAFE round and later does another convertible round at any time prior to doing a priced equity round.
Equity round investors
- Pre and Post-Money SAFEs: In both cases, rarely take dilution from prior investors.
Zero Pro-Rata Rights
Another important difference is the treatment of pro-rata rights. Pro-rata rights are the legal right for an investor to keep investing at subsequent financing rounds. This is an important right for hot startups where the fundraising rounds are oversubscribed and competition to invest is fierce. In the Pre-Money SAFE, pro-rata rights are a default component of the document. In the Post-Money SAFE, pro-rata rights are not included as default and must be affirmatively granted to the investor by the company.
Granting pro-rata rights is typically reserved for a startup’s most valuable investors, which typically means (i) the largest checks and (ii) the startup’s earliest backers. There is a school of thought that all angel investors should be given pro-rata rights given their level of risk and early support, but many feel that they are adequately compensated by the lower valuation they are receiving. I advise my clients to be judicious with granting pro-rata rights.
How to Decide Between Pre and Post-Money SAFEs
While each version of the SAFE document has its pros and cons, neither the Pre-Money SAFE nor the Post-Money SAFE is universally better for companies. They are two tools suited for slightly different situations. When deciding which version is right for your company, start by considering the level of fundraising you plan to gather during the given round. The parameters below represent a generalized summary of the scenarios I’ve witnessed in my experience with advising hundreds of startups. There are many exceptions to these guidelines.
Raising less than $1.0M? Push to use Pre-Money SAFEs.
In today’s startup environment, at this level of fundraising, you’re almost guaranteed that your next round would be a convertible round. As previously mentioned in the section on Share Dilution, opting for a Pre-Money SAFE in this situation would enable all stakeholders from this convertible round (founders, early employees, and investors) to each shoulder their relative portion of any dilution resulting from subsequent convertible rounds. This is fair and reasonable.
Raising between $1.0M and $2.0M? Pre or Post-Money, depending on the circumstances.
It can go either way for founders deciding between Pre and Post-Money SAFEs in this range. Recently we’ve seen most of these startups going with Pre-Money SAFEs, but I suspect that’s partially because investors are still becoming educated on the benefits of the Post-Money SAFE. However, early-stage investors have generally been sympathetic to the argument that they should participate in the dilution of a subsequent convertible round along with the team. This is the range where I suspect relative bargaining power and sophistication of the parties and their legal counsel to be the deciding factors, so there is increasing variance here.
Raising more than $2.0m? Expect to use Post-Money SAFEs.
At this level of fundraising, you likely have investors who’ve written large checks and have significant negotiating leverage. If they are sophisticated investors they’ll likely insist on a Post-Money SAFE because of the extra protection it affords them — and this isn’t necessarily a bad result for you as a founder because your company can certainly follow a $2M raise with an equity round (even if it is a small round), thereby allowing the parties to benefit from the clarity and other positive aspects of the Post-Money SAFE, while avoiding the disparate allocation of dilution.
Getting into an equity round earlier is also arguably good for corporate governance and requires management teams to level up their investor communications, which is almost always a good thing. Of course, this level of fundraising was done with Pre-Money SAFEs for years, so it’s certainly possible. However, I anticipate a paradigm shift here once investors, especially institutional investors, get more familiar with the Post-Money SAFE.
(Note: Again, as similarly stated at the top of this article, these are overly-simplified parameters and should not be used without thoughtful consideration and advice by qualified advisors and legal counsel. There are exceptions to these guidelines, and these should only be used as a way of gaining a general understanding of Pre and Post-Money SAFE use cases – not as a complete way of choosing which to use.)
Are You Able to Do an Equity Round as Your Next Raise?
Yes? Consider Post-Money SAFEs.
If you expect your following round will be an equity round, having the mathematical clarity on relative ownership positions, and not defaulting pro-rata rights to every investor can be an important consideration. Additionally, without a subsequent convertible round, you won’t have to deal with the issue of your team bearing disproportionate dilution. So in this scenario, you get all the benefits of the Post-Money SAFE, without any of its drawbacks.
No? Pre-Money SAFEs may be the better option.
In this situation, you don’t ask the team to eat the investors’ share of the dilution from subsequent convertible rounds. It is very unusual that an investor demand avoiding any dilution at a subsequent round, whether convertible or otherwise, if the company is raising more money so this is a very reasonable ask.
The company’s ability to raise its next round as a priced equity round is by far the most important consideration in deciding between Pre and Post-Money SAFEs so please be sure to investigate this point thoroughly.
Here to Stay
The Post-Money SAFE is relatively new on the scene. Founders and investors, alike, are still getting acquainted with it. While a complete understanding of the Post-Money SAFE requires a thorough review of the actual document, it helps to first understand the key elements that bear consideration. The Post-Money SAFE will better allow you to accurately track ownership and dilution changes as the fundraising round progresses. The Post-Money SAFE also allows more negotiation around pro-rata rights, and is often the SAFE of choice for companies that are confident their next round of fundraising will be for priced equity. The Pre-Money SAFE is typically the better option for small, initial financing rounds. To learn more and ask questions about Pre and Post-Money SAFEs, join me on April 16th for a webinar where I’ll dive in a bit deeper.