Pre-Money Vs Post-Money SAFEs

Fundraising for your startup is like navigating a strategic game of chess. You're strategically positioning your funding options such as ‘equity’, ‘convertible debt’, and ‘SAFEs’ to ensure the best outcome for your company's future.

Lately, SAFEs have gained popularity and are comparable to the Queen in a game of chess. Yet, many founders find themselves unsure about which type of SAFE to use and how it might impact their equity.

What is a SAFE (Simple Agreement for Future Equity)?

Think of SAFEs as IOUs (‘I owe you’) for future ownership.

SAFEs (Simple Agreements for Future Equity) are streamlined financing instruments that allow investors to provide capital to startups in exchange for the future right to convert that investment into equity (ownership shares) in the company. This is particularly useful in early-stage funding where a fixed valuation might be challenging to determine.

While convertible debt and SAFEs are often used interchangeably, they are distinct instruments.

Convertible debt involves a loan that converts into equity upon a subsequent funding round and includes interest and a maturity date. In contrast, a SAFE is a direct equity instrument without interest or maturity, providing a simpler and more flexible option for early-stage funding.

What is a pre-money SAFE?

Pre-money SAFEs emphasize a valuation cap. If the company raises a future round of funding at a valuation higher than the cap, the SAFE converts to shares at the capped price, offering the investor a guaranteed return. Conversely, if the company's valuation is lower than the cap, the investor benefits from a lower share price (higher ownership percentage).

In a pre-money SAFE, the valuation is determined before the new investment is made. The valuation cap specified in the pre-money SAFE is not inclusive of the new investment amount.

Example:

Let's say a startup has a pre-money valuation of $1 million and issues a pre-money SAFE for $100,000 with a valuation cap of $2 million.

Scenario 1: Higher valuation in future round

If the company raises a future round at a valuation of $3 million, the SAFE converts at the capped valuation of $2 million. This means the investor gets shares worth $100,000 at a price per share that reflects the $2 million valuation, resulting in a higher ownership stake than if they had converted at the $3 million valuation.

Scenario 2: Lower valuation in future round

If the company raises a future round at a valuation of $500,000, the SAFE converts at the lower valuation. In this case, the investor gets shares worth $100,000 but at a price per share that reflects the $500,000 valuation, translating to a larger percentage ownership of the company.

Components of a pre-money SAFE

‍1. Valuation cap

‍This is the maximum valuation at which the SAFE can convert into equity. It protects investors by ensuring they receive equity at a valuation below the cap, even if the company's valuation skyrockets.

‍2. Discount rate

‍The discount rate allows investors to receive equity at a lower price per share compared to the valuation in the subsequent financing round. It incentivizes early investment and compensates investors for the risk they take by investing in the company at an earlier stage.

‍3. Conversion trigger

‍The pre-money SAFE typically converts into equity at the valuation of the next priced equity financing round, triggered by a specific event such as the closing of a qualified financing round.

‍4. Equity percentage

This represents the percentage of the company's equity the investor will receive upon conversion of the SAFE. It is calculated based on the investment amount, valuation cap, and discount rate.

What is a post-money SAFE?

Post-money SAFEs specify the ownership percentage at which the SAFE would convert. This approach offers investors a more predictable ownership stake but removes the potential upside of a valuation cap.

Example:

Continuing with the same $1 million pre-money valuation startup, let's say they issue a post-money SAFE for $100,000 with a conversion clause granting 10% ownership upon a qualified equity financing round and a post-money valuation cap of $1.5 million.

The new investment of $100,000 increases the post-money valuation to $1.1 million (following the formula: post-money valuation = pre-money valuation + new investment).

If a qualified equity financing round occurs and values the company at post-money valuation of $2 million, the investor will still convert based on the capped valuation of $1.5 million, resulting in shares worth $150,000 (10% of $1.5 million).

The SAFE investors and founders both dilute after the conversion of the post-money SAFE during the subsequent equity financing round, re-adjusting the ownership stake of existing shareholders.

So in the above example, the SAFE investor's 10% ownership (based on $1.5 million cap) translates to 7.5% ownership of the now $2 million company (150,000 shares / 2,000,000 total shares)

Choosing between pre-money and post-money SAFEs depends on the specific circumstances of the startup and the investor's risk appetite. Pre-money SAFEs offer more protection for investors in situations with high growth potential, while post-money SAFEs provide more certainty in ownership stake for founders.

Components of a post-money SAFE

‍1. Equity percentage‍

Post-money SAFEs give investors and founders a clear understanding of the equity percentage of SAFE investors upon conversion. This is determined by the investment amount and the valuation of the subsequent financing round.

‍2. Conversion valuation

‍The post-money SAFE converts into equity at the valuation of the next priced equity financing round, or at a predetermined valuation cap, if one exists. Unlike pre-money SAFEs, discount rates typically do not apply to post-money SAFEs.

‍3. Conversion trigger

Similar to the pre-money SAFE, the conversion of a post-money SAFE is triggered by a specific event such as the closing of a qualified financing round.

‍4. Conversion mechanics‍

Post-money SAFEs may include additional provisions or adjustments to protect investors and ensure a fair conversion, such as provisions for conversion in the event of a down round or changes in the company's capital structure.

‍Pre-money Vs post-money SAFEs

The battle between pre-money and post-money SAFEs is a constant negotiation point for founders and investors in early-stage funding.

Pre-money SAFEs: A preferred choice for investors

‍1. Potential for outsized returns for investors

Investors favor pre-money SAFEs because they offer the chance for significant ownership stakes if the company experiences a valuation boom before conversion.

‍2. Drawback for founders

The flip side is the potential for major dilution. If the valuation doesn't soar as expected, the investor might end up owning a much larger chunk of the company than anticipated, causing founders to lose significant control.

Post-money SAFEs: A preferred choice for founders

1. Predictability for founders

Founders seeking clarity over ownership dilution favor post-money SAFEs. They know exactly what percentage of the company they're giving away upfront, regardless of future valuation. This allows for better financial planning and avoids surprises.

‍2. Investor caution

Investors might be less enthusiastic about post-money SAFEs because they limit their potential upside in a high-growth scenario. They're giving up the chance to secure a massive ownership stake if the company takes off.

‍3. Potential disadvantage for founders

In a down round (where the valuation falls in the next funding round), post-money SAFE investors might get converted at a higher price per share than the current investors, creating a pricing disparity.

P.S. Y-combinator SAFE notes are the gold standard for structuring SAFEs. Do refer to it if you are planning on raising your next round using SAFEs

Understanding the intricacies of equity financing, and the nuances of SAFEs is crucial for founders to carefully weigh the pros and cons of each option and strike the right balance between securing capital and preserving ownership.

Whether opting for pre-money or post-money SAFEs, the goal remains the same: to fuel growth while safeguarding the interests of both investors and founders. By navigating these financial intricacies with clarity and foresight, startups can position themselves for success in the competitive landscape of venture capital.