This article is the first in our 3-article series on SAFE conversions and dilution impacts.
The example provided shows the impact on ownership and dilution for both investors and Founders from 3 rounds of pre-money SAFEs.
TLDR: Our key findings are
- Pre-money SAFEs result in dilution ‘sharing’ between Founders and investors.
- Unknown dilution risk for pre-money SAFE investors arise from additional SAFEs issued after theirs. Therefore, be mindful if a portfolio company is missing equity round targets.
- Founders and investors are somewhat aligned in avoiding unnecessary dilution through the use of pre-money conversion SAFEs.
Check out the 2nd article in this series where we examine post-money SAFE conversion.
Introduction
Pre-money SAFEs were introduced by Y Combinator in 2013 and became a standard over convertibles for their simplicity.
This was updated to post-money conversion in 2018 and became broadly adopted in H2 2021. Our article ‘7 Ways post-money SAFES affect Founders and Angel Investors’ explains all these changes.
The most substantive impact of this change has to do with dilution. At the time of an equity qualified financing, SAFEs are converted:
- Pre-money SAFEs: Multiple rounds of pre-money SAFES results in dilution for both by Founders and investors.
- Post-money SAFEs: Multiple rounds of post-money SAFES places dilution entirely on Founders.
Both pre-money and post-money SAFEs are subsequently diluted by the equity round.
The following example illustrates the impact on ownership and dilution for investors and Founders from 3 rounds of pre-money SAFE financing. It simulates conversion during a qualified equity financing where the SAFEs convert at the valuation cap (not the discount).
Note that immediately following SAFE conversion, the equity financing results in new shares being issued which would introduce further dilution. This is not reflected in this calculation for simplicity.
Step 1: Company Founded
Upon founding the company, 100,000 shares are created and 10% is set aside for current and future employees. The founders retain 90,000 shares and allocate 10,000 to an ESOP.
Their cap table looks like this:
Step 2: Pre-Money SAFE 1
The company raises $2MN on pre-money SAFE. It has a valuation cap of $8MN pre ($10MN post) and 0% discount.
If an equity financing takes place above the $8MN valuation cap, the pre-money SAFE converts to equity based on this calculation:
- Share price = $8MN / 100k shares = $80 share price
- Pre-money SAFE 1 receives $2MN / $80 share price = 25,000 shares
Prior to the equity round dilution, pre-money SAFE 1 investors own 20% of the company. Founders and ESOP are diluted down to 72% and 8% respectively.
The resulting cap table looks like this:
Step 3: Pre-Money SAFE 2
Some time after taking in pre-money SAFE 1, the company decides to raise an additional $3MN on a new pre-money SAFE. It has a valuation cap of $15MN pre ($18MN post) and 0% discount.
If an equity financing takes place above the $15MN valuation cap, pre-money SAFE 1 converts into 25,000 shares (same as step 2).
Pre-money SAFE 2 converts to equity based on this calculation:
- Share price = $15MN / 100k shares = $150 share price
- Pre-money SAFE 2 receives $3MN / $150 share price = 20,000 shares
Founders and ESOP still hold 100,000 shares. The issuance of new shares to pre-money SAFE 1 and pre-money SAFE 2 results in 45,000 new shares being created.
As a result, prior to the equity round dilution, the issuance of pre-money SAFE 2 further dilutes everyone on the cap table.
The cap table looks like this:
Step 4: Pre-Money SAFE 3
Let’s say the company decides to take in additional SAFE financing. They raise an additional $5MN on a new pre-money SAFE. It has a valuation cap of $25MN pre ($30MN post) and 0% discount.
If an equity financing takes place above the $25MN valuation cap, pre-money SAFE 1 converts into 25,000 shares (same as step 2) and pre-money SAFE 2 converts into 20,000 shares (same as step 3)
Pre-money SAFE 3 converts to equity based on this calculation:
- Share price = $25MN / 100k shares = $250 share price
- Pre-money SAFE 3 receives $5MN / $250 share price = 20,000 shares
Founders and ESOP still hold 100,000 shares. The issuance of new shares to pre-money SAFE 1, pre-money SAFE 2, and pre-money SAFE 3 results in 65,000 new shares being created.
As a result, prior to the equity round dilution, the issuance of pre-money SAFE 3 dilutes everyone on the cap table even more!
The cap table looks like this:
Conclusion
Multiple rounds of pre-money SAFE financing results in dilution for Founders and SAFE investors upon conversion. The dilutive impact is ‘shared’ by Founders and investors.
As a SAFE investor, the addition of new pre-money SAFEs following your investment dilutes you. The table below- based on our example- captures the dilution impact of pre-money SAFEs 2 and 3 from the perspective of a SAFE 1 investor.
As such, be mindful if your portfolio company is missing equity round targets; they may require bridge financing that results in dilution.
That said, Founders and pre-money SAFE investors are aligned by a common interest to avoid unnecessary dilution.
Check out the 2nd article in this series where we examine post-money SAFE conversion.
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