Mechanics of Capitalization — SAFEs vs. Priced Equity Rounds
Last week we shared the Mechanics of Capitalization — How to Capitalize Your Startup where I presented a different approach to capitalizing a business. I demonstrated how taking less capital early on and raising only what you need to get to the next stage of your business results in more ownership to founders and early stakeholders, generating meaningfully more value to your net worth in the long run.
In this second part of the Mechanics of Capitalization, I will dive into the differences between SAFE Notes and Priced Equity Financing rounds and how each impacts the cap table. Note: I acknowledge every deal is different and this blog is simply meant to be informative.
Lets start with basic definitions:
SAFE Note (Simple Agreement for Future Equity): A financial agreement between a company and an investor promising future ownership in exchange for capital at the time of execution (see SEC Definition for SAFE here).
Preferred Stock (issued in Priced Equity Rounds): A type of security that represents ownership in a company with preferential rights over common stockholders defined in the security agreements (see SEC Definition for Preferred Stock here).
SAFE Notes have become a popular financing structure in the early-stages, especially in angel and pre-seed rounds, and have a perception of being “easy and clean”. SAFEs often include a valuation cap and/or a discount which derive the price per share upon conversion. With SAFEs you do not need to define and establish important protective provisions and governance protocols (ex: composition of the Board of Directors) which are a major part of Preferred Stock issuances in Priced Equity Rounds. Note: To mitigate this many institutional investors such as VC firms will require a side letter or management rights letter accompanied with the SAFE in order to invest.
As such, SAFEs are typically faster and cheaper to execute thanks to lower legal bills and fewer reviews.
Although that may make sense at the earliest stages, I have seen some founders continue to raise on SAFE Notes in subsequent fundraising rounds, stacking totals north of $5M outstanding on SAFEs. In addition to kicking the can down the road on key governance issues, such an approach can also have major negative ramifications to the cap table and be highly dilutive.
When SAFE Notes convert at the next equity financing or liquidation event, new (additional) Preferred Shares owed to the previous investors are created and added to the cap table. These SAFE holder shares are created concurrently, typically right before the new equity shares for the incoming capital are created (depending on capitalization definitions). That means the shares of the SAFE holders do not dilute each other regardless of when that capital came in. On the other hand, with Priced Equity Financing rounds, the Preferred Shares are created at the time of investment, hence the dilution takes place immediately and does not accrue.
I will use an EXTREME example to demonstrate how this plays out:
Scenario 1: Raising every round on post-money SAFEs with defined valuation caps.
Scenario 2: Raising every round on Priced Equity with defined valuations.
Take note of the Total Shares count which is effectively what happens to the cap table in the different scenarios. Comparing the two in this extreme example, it is easy to see that raising multiple rounds on SAFEs can result in a higher dilution hit to founders’ ownership compared to raising the same amount in Priced Equity Rounds.
Of course, as previously stated, every situation is different and the potential outcome depends on the details and defined terms. This exercise is simply meant to help founders better understand how the security type used for financing may impact you and your stakeholders in the future.
In summary:
SAFEs are typically faster and cheaper to execute.
SAFEs have fewer rights and governance protocols defined and can be more dilutive.
Priced Equity rounds are typically longer to execute and more expensive.
Priced Equity rounds define standard governance protocols and preferred rights and can be less dilutive.
My two cents:
SAFEs make sense for very early-stage companies and smaller rounds (<$2M) because at those stages it is more important to focus on establishing a business than getting bogged down in governance. However, as a business matures, SAFEs are not fiduciarily responsible and sophisticated investors in later financings will almost certainly required Priced Equity Preferred Shares in order to invest.
If you have any questions on the Mechanics of Capitalization and would like to discuss further, please reach out!
Authored by Idan Levy (Watertower Ventures)
