# Evaluating the Risks of SAFEs for Founders: Capped Valuations and Dilution Dynamics
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Chapter 1: Introduction to SAFEs
Since their inception in 2013, SAFE notes have become the preferred method for early-stage fundraising among founders in North America. A SAFE, or Simple Agreement for Future Equity, is essentially a commitment to provide investors with shares in the future in exchange for immediate capital. There are four primary categories of standard SAFE documents, which can be visualized in a 2x2 matrix based on whether they include (1) a valuation cap or not, and (2) a discount or no discount.
Various modifications of SAFEs exist, including Most Favored Nation (MFN) clauses and distinctions between pre-money and post-money valuation caps. However, for the sake of clarity, this discussion will focus on a straightforward SAFE with a post-money valuation cap and no discount. If you're already familiar with SAFEs, feel free to skip to the next section.
Basic Characteristics of a SAFE
A SAFE is fundamentally a contract that outlines how an investor's funds will convert into shares. The critical components include:
- Investment Amount: This refers to the amount an investor contributes to the company. For example, let's consider an investment of $100,000.
- Conversion Triggers: This indicates the conditions under which the investment converts, usually linked to a financing event or a liquidation event.
- Conversion Process: This describes how many shares the investment translates into, which can be more complex. The investor receives a promise for shares contingent on a future conversion event. The conversion is determined by three factors:
- Valuation: This is the total value of the company calculated as the total shares multiplied by the price per share. For simplicity, let's assume the company's valuation is $1 million, based on 100,000 shares priced at $10 each.
- Valuation Cap: To account for the uncertainty of the company's future value, a valuation cap is established. For our example, let’s set the cap at $500,000.
- Conversion Price: When a conversion occurs, the price will be the lesser of the valuation cap or the market price at the time. Since $500,000 (the cap) is less than the $1 million valuation, the conversion price will be based on the cap, resulting in a price of $5 per share rather than $10.
Using the example above, the $100,000 investment would convert into 20,000 shares, which is 20% of the company. On paper, those shares would be worth $200,000, effectively doubling the investor's initial amount.
The Benefits for Founders
SAFEs are often hailed as a founder-friendly fundraising tool, primarily because they limit the rights that founders must cede to investors. This simplifies negotiations down to the valuation cap, streamlining the fundraising process while preserving founders' control.
What existed before SAFEs? Here are the alternatives:
- Priced Equity Raises: Here, the valuation is determined upfront, allowing investors to buy equity and establish a "market price" for shares. This approach usually involves detailed term sheets, which come with extensive rights for equity holders, including management rights and board representation.
- Convertible Notes: These are debt instruments with conditions such as maturity dates and interest rates. Unlike SAFEs, convertible notes carry obligations for the company and can lead to automatic seniority and liquidity preferences.
- Debt Financing: Traditional debt often requires some form of collateral or cash flow, which many early-stage startups lack.
Risks and Considerations for Founders
While SAFEs are generally advantageous for founders, there are potential pitfalls that should be considered. One significant concern is the lack of a valuation floor, leading to the risk of excessive dilution, especially in a down economy.
For instance, consider a scenario where a startup raises $3 million under a SAFE with a $20 million cap. Initially, this results in a 15% dilution. However, if the company's valuation drops to $10 million, the dilution can surge to 30%.
Down Round Impact
Let’s explore a hypothetical situation where the company needs to raise an additional $1.8 million amidst a down round. In this case, founders could see their equity stake drop to as low as 68% after accounting for employee option pools. This scenario illustrates how quickly dilution can escalate, particularly in challenging economic conditions.
Market Dynamics
It’s crucial to note that these scenarios are not merely theoretical. Real-time market conditions, as evidenced by companies like Klarna, demonstrate that valuation compression is occurring across the board, impacting early-stage startups.
Negotiation Power
Founders may find themselves at a disadvantage when negotiating new funding rounds. When a SAFE is in place, investors may push for terms more favorable to them, further complicating the fundraising landscape.
Next Steps for Founders
In light of current economic conditions, founders should focus on extending their runway and minimizing expenses. Considering alternative funding instruments and understanding their potential trade-offs can help mitigate risks associated with SAFEs.
For example, a priced equity raise could distribute future dilution more evenly among investors. Convertible notes may provide a less aggressive conversion price and include repayment options, while debt financing, though challenging to obtain, comes without dilution concerns.
Concluding Thoughts
As early-stage companies navigate increasingly complex capital structures involving various equity and debt instruments, founders must remain vigilant. The balance between equity and debt holders can create agency conflicts that complicate fundraising efforts.
Ultimately, being prepared for potential down rounds, cultivating supportive investor relationships, and having confidence in one’s venture are essential for survival in today’s fluctuating market.
Disclaimer: This content is not intended as legal or financial advice. It reflects the author's perspective on the implications of SAFEs for founders.