Bridge Financings: Raising Money Between Equity Rounds — Part 2

SAFEs and convertible notes were designed to be used before a priced equity round, and many of the terms don’t align with parties’ intentions between rounds.

This is part 2 of a series walking through the right changes to make to SAFEs/notes to reflect the right economics between equity rounds.

See Part 1 — The Valuation Cap

Part 2 — The Discount

The discount on a SAFE/note is designed to ensure an early investor gets in at a lower valuation than a later investor. The SAFE/note converts at a valuation that is X% (usually 5–20%) lower than the valuation in the priced equity round. The amount of the discount usually corresponds with the amount of time between the SAFE/note investment and the priced equity round. The closer to the priced equity round, the smaller the discount.

SAFEs/notes with discounts are often the very first money into the company. Two frequent justifications for using a discount instead of a valuation cap are:

1. The investors lack the experience or don’t have the time/resources to conduct sufficient diligence to determine an appropriate cap. After all, angels don’t have associates to scout the market and comparable companies.
2. The company is so early that it is difficult to determine an appropriate valuation cap.

In recent years, most early convertible rounds are SAFE rounds, and in most SAFE rounds, if parties are able to agree on a valuation cap, they no longer include a discount — this makes sense in light of the justifications described in Part 1. However, some investors (usually convertible note investors) still push for discounts in addition to caps — the typical justification being that the round involves non-institutional investors and the company is so early that the valuation cap may be wildly off, so those early investors still want to ensure they are coming it a lower valuation than the later priced equity round.

After a priced equity round, however, investors generally don’t have those justifications. In bridge rounds, the main justification for a discount-only SAFE/note is that the next round is imminent — why go through the effort of negotiating a valuation if the lead investor in the next equity round will set the valuation?

Key takeaway — after a priced equity round, SAFE/note investors may negotiate a discount instead of a valuation cap, not both. If a convertible investor between equity rounds has both a discount and a cap, the convertible investor receives better than full down-round protection, which is more investor-favorable than the standard weighted average anti-dilution protection afforded an equity investor, and more investor-favorable than even full ratchet anti-dilution (which is exceptionally rare). See the down-round discussions in Part 1 regarding the valuation cap.

In addition, after a priced equity round, a discount shouldn’t apply in a down-round. The SAFE is a bridge between priced equity rounds, so you would expect the SAFE valuation to be between the valuations of those two rounds. Thus, a discount only works if the next round is an up round. Let’s say the Series A was at a $50M valuation, a 20% discount-only SAFE is issued leading up to the Series B, and the Series B is at a $100M valuation. The SAFEs would convert at an $80M valuation (20% discount to $100M Series B valuation) as a reward for investors putting their money in earlier.¹ This chart showing the 20% discount applied to an up round makes sense:

However, if instead the startup had to raise a down Series B round at a $40M valuation, it wouldn’t make sense for the SAFEs to convert at a $32M valuation (20% discount to $40M). Sure, there may be the rare instance of a startup’s valuation dropping to its lowest point at the SAFE round and rebounding slightly at the Series B, but in most cases the SAFE round occurred when the startup’s valuation was somewhere between the A valuation and the B valuation.

Here is a chart showing why applying a discount in a down round likely does not make sense:

There is a similar issue if the B is at a slight up round, let’s say $55M. The SAFEs would convert at a $44M valuation ($55M * 0.8), which is below the A round valuation ($50M).

To sum it up, if you’re using a discount for a SAFE/note between equity rounds:

1. If the next round is a flat or down-round, the discount should not apply.
2. If it is a small up-round, the discount should not result in a valuation below the A round.
3. There should be no valuation cap.

Here is a chart showing the convertible discount not applying, because the B round was a down round:

Special thanks to Jeremy Raphael for his insights.

Part 1 — The Valuation Cap

Part 3 — Timing

Part 4 — Exits and Convertible Note Nuances (Maturity and Interest)

Footnote:

(1) Pre vs. post-money valuations are ignored for simplicity.