In August 2010, Paul Graham tweeted:
The tweet sparked a heated debate among those in Silicon Valley — Fred Wilson, Seth Levine and Bill Burnham all posted essays debating whether Paul Graham was right and, if he was, whether convertible debt “winning” was a good thing.
It’s now 13 years later and most Angel, Pre-seed and Seed rounds are done using the standard Y Combinator (YC) Simple Agreement for Future Equity (SAFE), and it’s not hard to see why. Compared to priced rounds, SAFEs are faster, cheaper, and don’t require the founders to decide on a valuation — a feature that is particularly useful in times like this when the VC market is uncertain.
Despite the ubiquitous nature of SAFEs in the VC world, they aren’t a foolproof way to raise capital, and founders should be aware of the following pitfalls when using them.
Pitfall 1: Stacking SAFEs
The YC SAFE is simple to use: download it, fill in a few blanks, send for signature, and wait for the wire to hit your corporate bank account. The simplicity of SAFEs serves both as its superpower and kryptonite — because it’s so easy to use, it’s tempting to issue too many SAFEs.
Instead of conducting a priced round, which typically take 4-6 weeks to close, founders can raise capital in a matter of days using the SAFE. In addition, founders can raise multiple rounds of capital in quick succession and with different valuation caps and/or discount rates — all while kicking the conversation of company valuation down the road. Angel investors also like SAFEs because they're easy to understand, which means they don’t have to spend money sending them to an attorney for review.
However, if a founder doesn’t keep track of the number of SAFEs outstanding and how much equity these SAFEs will convert into, she will be in for an unpleasant surprise at the priced round in which the SAFEs convert. Although SAFEs are an easy way to raise capital, they can dilute you more than anticipated if you don’t understand their conversion economics.
Take this example previously shared on our Twitter. A founder raises three SAFE rounds:
- An angel round of $1MM with a $10MM post-money valuation cap
- A pre-seed round of $2MM with a $20MM post-money valuation cap
- A seed round of $3MM with a $30MM post-money valuation cap
After each of these rounds, the founder has given away 10% of her company – meaning she's given away 30% of her company before she’s ever raised a priced round. Here’s how the math works:
- $1MM / $10MM = 10%
- $2MM / $20MM = 10%
- $3MM / $30MM = 10%
Now, when she goes to raise a priced round (let’s assume a Series A), the typical lead investor will likely require around 20%-25% of the company post-financing. So, after the Series A, the founder has given away 50% of her company (30% to the SAFE holders + 20% to the Series A lead investor). Giving away this much of the company early in her company’s life cycle will make it hard to raise additional rounds of financing because future investors will not be able to own enough of the company post-financing to make their investment worth it (we discuss this in more detail below). Not to mention, the founder will be less incentivized to give all of her time to the company if she does not even own a majority of the company’s equity.
So, yes, SAFEs are a great way to raise capital, but founders should be cautious with how many SAFEs they’re issuing and at what valuation caps and/or discounts. It’s fairly easy to calculate ownership and dilution with one SAFE round, but as founders start to do two or three different SAFE rounds (sometimes with various valuation caps and discounts) it becomes easy to lose track of how much of the company the founder is giving up. All too often, this leads to unpleasant surprises at the priced round when investors and founders find out they own less of the company than they thought.
Pitfall 2: Discouraging Future Investment
Having too many outstanding SAFEs can prevent a new lead investor from wanting to invest in your company. Investors must reach certain ownership targets in order to receive a sizeable return on their investment. If you've given away too much of your company prior to a priced round, new investors may not own enough of the company post-financing for them to invest. While investors have different views on what makes a successful return on investment, some investors expect every investment they make to have the potential to return their whole fund. Investors will model what the company could be sold for, or IPO at, to determine the ownership percentage they would need to return their entire fund. However, the larger the fund the harder it is to have one portfolio company return the entire fund, so other investors will look to make investments in companies that will provide enough ownership so that they can return between 25%-50% of their fund. There is no set rule of thumb for how much investors will want to own post-financing, but in general they will want to own an amount that sets them up to have outsized returns in the future.
Let’s use an example where a company is raising a Series B financing. In the past, they’ve raised three rounds: a Seed, Series A, and a bridge round.
At the Seed round, they raise from two investors with different post-money SAFEs:
- SAFE 1: $100K on a $1MM valuation cap = 10% of the company.
- SAFE 2: $200K on a $2MM valuation cap = 10% of the company.
The company then raised a $4MM Series A round with a $20MM post-money valuation, so they gave away another 20% of the company. After the Series A, the founder has given away 40% of the company to its investors (10% + 10% + 20%).
The company struggles to generate revenue after their Series A so they decide to raise a bridge round instead of a Series B. The company reaches out to its angel investors who agree to give the company $5MM on SAFEs with a $25MM post-money valuation cap. The company sees this as a chance to extend their runway without having to negotiate a valuation, so it does the SAFE round.
At this point, the existing investors already own 60% of the company (counting the 20% of the company that the SAFE holders will own post-conversion of the SAFEs).
Let’s assume one year later the company is generating more revenue, but is also spending more to hire new employees, so it seeks to raise its Series B and receives a term sheet for $8MM at a $40MM post-money valuation. The company is now in a tough position. Given the post-money valuation, it doesn’t make sense for the investor to own less than 20% of the company post-financing because it’s unlikely they’ll realize an outsized return. However, if the company agrees to this deal, it’ll have given away 80% of the company. This means not only will it be hard for the company to raise money in the future, but the founders now only own 20% of their company and will likely need to raise additional capital before an IPO or M&A exit.
The lesson here is that SAFEs can result in you giving away too much of your company such that you deter future investment. Investors have ownership targets so will not agree to deals that don’t make sense for the returns their LPs expect. These investors have to ask themselves whether their ownership percentage multiplied by the amount of money the company might exit for will result in a significant payday for them – and a messy cap table with too much SAFE overhang, and not enough allocation, can be a reason for them to choose not to invest in your company.
Pitfall 3: Thinking Valuation Cap = Your Company’s Valuation
The valuation cap in a SAFE is not the valuation of your company. One of the rationales behind implementing a SAFE is that valuations are hard to calculate when the company is pre-revenue and pre-traction, which is often when founders want to raise capital using a SAFE. Using a SAFE means, you delay figuring out the valuation of your company until you raise a priced round, and ideally, have more solid economic indicators (such as revenue and customers) to justify your valuation.
It’s a common mistake to think that the SAFE valuation cap and your company’s valuation are interchangeable. A founder who raises a SAFE with a valuation cap of $15MM might think that $15MM is now the lowest possible valuation of the company at the priced round. It’s not. The valuation of their company will only be set when a lead investor prices it, and that valuation can be higher or lower than $15MM. Of course, your SAFE investors don’t want the valuation to be lower in the priced round because they want a discount on their shares (which is what the valuation cap and discount are intended to provide) as an added incentive for investing in the company early.
Unlike the post-money valuation at a priced round, the valuation cap is not the market value of your company. Instead, it serves a different purpose – to help investors (and founders) understand how much of the company they will own post-conversion.
Sidestepping These Pitfalls: Some Suggestions
There’s a reason SAFEs are so common – they’re the most convenient way for founders to raise capital. But, they’re still a legal document and if founders and investors don’t understand what they’re signing, nightmares can unfold at the priced round.
To avoid this, everyone in the venture ecosystem – founders, venture funds, syndicates, angel investors – should keep some guidelines in mind:
- Avoid doing multiple SAFE rounds with multiple valuation caps and varying discounts, especially on pre-money SAFEs, which are more difficult to dilution because of their conversion mechanics (learn more about the difference on our Venturepedia). Stacking SAFEs can be a quick road to dilution.
- Understand dilution. Whenever you issue a SAFE, put together a pro forma cap table that shows how much of the company each stakeholder will own when the SAFE converts. We love this one from Carta.
- Remember that SAFEs don’t operate in isolation. They may contain pro rata rights and MFN clauses that can substantially affect the allocation and dynamics of the priced round.
- Don’t assume the valuation cap is your valuation.