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How SAFEs will convert at Series A
BY Pavitra Bhalla

The excitement of starting a company usually brings with it the realization that you need to raise money.

Five years ago, the startup accelerator Y Combinator introduced an instrument known as a simple agreement for future equity (SAFE). SAFEs streamline early-stage fundraising and save both startups and investors time and money they would otherwise spend drafting one-off legal agreements.

The evolution of SAFEs, which have become the standard for startups setting out to raise seed money, shows the power, as the venture capitalist Ramy Adeeb has observed, of building something people want and then making it better. It also shows the value of software tools and SAFE Genie that LTSE offers as a public service for entrepreneurs.

Overcoming uncertainty

As the name suggests, a SAFE brings money into a company in exchange for a promise to issue the investor stock in an amount to be determined in subsequent rounds of funding.

Though SAFEs gained wide acceptance, they left founders without a way to know precisely how much of their company they had sold. Nor did investors always end up with the percentage of ownership they had in mind when they invested.

To overcome this uncertainty, last year Y Combinator introduced a so-called post-money SAFE, which, judging by its ubiquity, is a game changer because it enables a company and investor to determine right away how much ownership has been sold. It achieves that by, in effect, treating the capital raised via a SAFE as its own round.

A post-money SAFE relieves the burden on founders—who rightfully tend to be too busy building their product and winning customers—to calculate the dilution to their ownership that an investment will produce.

From experience working with founders the past two years, I know first-hand that calculating dilution using polynomial equations that are circular in nature will produce, at best, something less than 100% accuracy as a result of rounding errors.

A trade-off

Post-money SAFEs provide accuracy but come with a trade-off for founders. In their former incarnation, SAFEs diluted other SAFEs, which meant less dilution for founders. (It also meant that calculating dilution was impossible without a tool such as SAFE Genie.)

While post-money SAFEs enable founders to know right away how much of their company they have sold, they alone experience the dilution. In short, post-money SAFEs do not get diluted by other SAFEs.

To balance dilution somewhat, holders of post-money SAFEs and founders will share dilution from the option pool in the Series A round of funding equally. For founders, that avoids an outcome in which they shoulder the burden of the option pool increase, which tended to be the case previously.

Consider this as well. Post-money SAFEs do not, by default, give investors the right to participate in subsequent rounds of funding. To address this, the parties to a post-money SAFE can negotiate a side letter that will confer the right to invest in Series A while maintaining their percentage ownership in the company. Because companies know who owns what, a post-money SAFE enables founders to calculate precisely how much equity to reserve for investment in their Series A by SAFE holders.

Getting better all the time

Thanks to improvements, the post-money SAFE marks a major upgrade from its predecessor in terms of transparency. Thanks to such SAFEs, founders now can map out a seed round, reward their earliest investors, and raise as much money as they could previously but with reduced risk of over-dilution.

Here at LTSE we look forward to learning how this plays out. We also know that in practice, a number of companies that plan to raise money via a post-money SAFE may have raised money previously via a pre-money SAFE. So the calculations can complicate quickly.

LTSE’s can help. It lets you create a capitalization table in the cloud and model the effects of both pre-money and post-money SAFEs. The top law firms that counsel tech startups can support you with as well.

We’ve also built SAFE Genie, a stand-alone calculator that lets you explore the impact of SAFEs and convertible notes without requiring you to share all the data in your capitalization table or to sign in. When you start to plan for your first priced round, take the 20-min assessment in Series A Ready to know what it takes to close the round and if you’re on track.

Disclaimer: LTSE is neither a law firm nor provides legal advice. Before making decisions on matters covered by this post, readers should consult their legal adviser.

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