Redbud VC is an early-stage venture capital fund and studio investing monetary and social capital in early-stage tech founders.
With the advent of SAFEs, raising funding as an early-stage tech startup founder has shifted from costing thousands to negotiate an obnoxiously long term sheet to utilizing a SAFE that takes about two minutes. As a result, 87%, 65%, and 53% of Pre-Seed, Seed, and all venture deals are financed via SAFEs, respectively [2021 State of U.S. Early-Stage Venture & Startups report.]. In addition, it’s easy to send multiple “Post-Money” SAFEs with varying terms to a group of investors. SAFEs allow founders to raise capital on a rolling basis and push investors who are on the fence to make quick decisions.
Seems fantastic, right?
But every time something starts feeling too “SAFE,” don’t forget that the devil is in the details! It’s often forgotten that Post-Money SAFEs pile up and convert together as one round; therefore, they don’t dilute each other (i.e., causing more dilution for the founders). Plus, the following priced round investors will most likely require the company to maintain an employee stock options pool (“ESOP”) of 10–20%, which will need to be increased post-investment, further diluting the founders.
Simple Agreement for Future Equity (“SAFE”): A SAFE is a convertible investment vehicle representing an agreement for future equity. The investment doesn’t convert to shares until there is a priced round (i.e., price per share set by investors buying stock) or liquidation event (e.g., sold or acquired). The conversion metrics vary based on the terms.
An alternative to Post-Money SAFEs is Pre-Money or uncapped SAFEs. Though many investors are against Pre-Money or uncapped SAFEs because they don’t know the equity they will receive until the SAFE converts, these SAFEs can be more founder friendly. Below are the most common terms used for SAFEs:
Post-Money: A Post-Money investment converts at a cap, and the future equity stake is known unless there is a discount. For example, $1M invested at a $10M Post-Money cap would equal 10% of equity purchased ($1M/$10M). If there is a discount, the note would convert at the most favorable conversion for the investor. Therefore, if there is a 20% discount and the following priced round was below $10M or $12.5M ($10M/(1–20%)), the investor’s SAFE would convert at 20% of the round’s share price.
Pre-Money: A Pre-Money SAFE investment converts at the Pre-Money cap divided by the number of shares issued and outstanding. For example, if the company has 10M shares issued and outstanding, then a $9M Pre-Money Cap/10M shares would equal $0.90 per share. Therefore, the investment would buy 1.1M shares or 10%, but if there were preceding Pre or Post-Money SAFEs, they would dilute the 10%. If there is a discount, the note would convert in the same scenario above.
Note: If there is a priced round below the cap and there is no discount, the SAFE will convert at the current priced round’s preferred stock share price.
*The most significant difference between Pre and Post-Money SAFEs is that Pre-Money excludes all securities converting in the financing (such as SAFEs and convertible notes), called “converting securities,” whereas Post-Money includes them.
Discount: On SAFEs, if a discount is applied, it is displayed as 1-discount; e.g., 1–20% is 80%. Do not be alarmed if the SAFE shows an 80% discount, it means the stock is purchased at 80% of the current share price.
Most Favorable Nation (“MFN”): Due to uncapped notes increasing in popularity, the MFN has become more popular because it means the SAFE will convert at the most favorable terms signed for all by converting securities before the subsequent priced round.
If the subsequent price round is below the cap, MFNs and discounts can serve as down-round protection.
Uncapped: Uncapped SAFEs are generally paired with a discount and/or MFN because they convert at the priced round’s share price.
Side Letter: Side letters are an easy way for investors to add terms not included in the typical SAFE (e.g., information or pro rata rights).
An alternative to SAFEs is convertible notes representing convertible debt, not future equity. Convertible notes can be paid off before converting to equity. It’s also common that the note has an interest rate, accumulating as paid in kind (“PIK”) interest that tacks onto the convertible note principal amount. Therefore, when the convertible note converts, it would purchase more equity due to the interest. For example, a $1M convertible note with a 5% interest rate would be $1.05M after 12 months ($1M x (1 + 5%)).
From day 1 of founding a company, it’s an excellent exercise to produce scenarios of what future dilution could be so that i) founders are not blindsided by dilution and ii) fundraising and hiring can be planned accordingly.
The following calculator entails nearly every common term and intricacy that may affect a founders cap table: https://docs.google.com/spreadsheets/d/1DbsZRLCZL0LNJk9RPSCft-fzPpEQOOu3/edit#gid=1601372072
Instructions for the Cap Table Simulator and Dilution Calculator
Hardcode the outstanding shares and existing or target employee stock option plan (“ESOP”)
Toggle whether the options pool will be dilutive (e.g., subsequent financing dilutes the ESOP) or non-dilutive (e.g., the ESOP is maintained at a predetermined percentage — usually 10%-20%)
2. Convertible Investment:
Toggle if it’s a SAFE or convertible note
Choose Post-Money, Pre-Money, no cap, or MFN for the note conversion
Choose whether the convertible instrument has a discount and what that discount is
If there is a cap, choose the amount of the cap
The most favorable term will automatically convert based on the priced-round assumptions
3. Priced Round:
Each subsequent price round needs an investment amount and Pre-Money valuation
If the options pool is non-dilutive, then hardcode the increase in shares needed — reference Column R to ensure the increase is correct. There is an ESOP check that says “Yes” or “No” if non-dilutive
4. *Only if Convertible Notes:
Hardcode the term and interest rate of the convertible note
Hardcode “Yes” or “No” if the note will be paid off
5. Cap Table:
Voila, the cap table automatically populates and displays the percentages owned and shared issued
Whether an investor, founder or employee, the number of shares owned by the stakeholder can be hard-coded to understand what percentage of equity will be owned based on the financing assumptions
6. Bonus *QSBS:
The forecasted stock appreciation gains also show the tax savings of Qualified Small Business Stock, Section 1202 of the tax code, if the stock is sold (roughly 23.8% + state tax savings). More about QSBS can be found via QSBS Expert here: https://www.qsbsexpert.com/what-is-qsbs/
DO NOT CHANGE CELLS THAT ARE NOT YELLOW WITH BLUE TEXT
Redbud VC is an early-stage venture capital fund and studio investing monetary and social capital in early-stage tech founders. Reach out to Brett Calhoun, Managing Director & GP at Redbud VC, at firstname.lastname@example.org to learn about Redbud, and subscribe to our newsletter here.