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For early-stage financing rounds (e.g., pre-seed and seed), SAFEs and Convertible Notes are often the investment instrument of choice for founders and funders alike.
SAFEs and Convertible Notes only include a few key terms (e.g., discount rate, valuation cap), making them easier to negotiate, and SAFEs, in particular, come in industry-accepted forms, such as those provided by YCombinator.
Although SAFEs and Convertible Note provide an efficient way to raise early-stage capital, many standard terms produce unanticipated results in later funding rounds. These consequences are beyond simply raising too much on a low valuation cap.
Many of these consequences, however, can be avoided by raising a priced round and issuing “series seed” preferred stock.
When founders hear “priced round” they tend to think of a Series A round, which is a fairly sophisticated and expensive round despite the adoption of industry-standard documents, such as those provided by the NVCA.
Generally, this is because Series A investors are investing a large enough amount of capital to warrant the negotiation of a whole bundle of economic and non-economic rights.
Even at the seed stage, however, it may be beneficial to raise a priced round rather than kick the valuation down the road and raise a round through SAFEs or Convertible Notes.
This is particularly true when an investor is willing to purchase equity and is relatively indifferent on terms other than the size of its investment, percentage ownership, liquidation preference, and anti-dilution protection.
To understand the economic consequences of raising a priced round v. a SAFE or Convertible Note round, let’s look at a company that is exploring two options for its seed round.
Although these investments appear to be equivalent at first glance, a deeper dive shows that is not the case.
The valuation cap and discount can give an investor significantly better rights when it comes to the liquidation preference and anti-dilution protection when the SAFE converts to preferred stock at a later round (e.g., Series A).
Liquidation Preference
A liquidation preference gives a preferred stockholder the right to receive at least the investment amount before the common stockholders receive any proceeds from a sale or liquidation of the company.
For instance, in our example, the preferred stock investor will receive a 1x liquidation preference on the $1M investment. If the company sells for $1M, the preferred stock investor would be entitled to all transaction proceeds.
However, in the SAFE example above, the investor may receive a liquidation preference that is greater than 1x the $1M investment.
When the SAFE converts (e.g., at the Series A financing), the investor will receive preferred stock, which will come with at least a 1x liquidation preference equal to the Series A price per share.
However, the SAFE investor will not pay the price per share of the Series A preferred stock because the SAFE will convert at a lower price (the lower of the conversion price of the discount or the valuation cap).
On conversion, the SAFE investor receiving preferred stock at a discount of the price paid by the Series A investors creates a situation in which the liquidation preference associated with the SAFE is greater than the amount the SAFE investor initially invested (i.e., the investor received a discount).
Conversely, the investor purchasing preferred stock at the “series seed” price round will have a dollar for dollar liquidation preference based on the amount invested without any discount. Remember, the investor invested $1M and received a 1x liquidation preference ($1M).
The benefit related to the liquidation preference received by the SAFE investor is relatively minor if the SAFE’s conversion price is based on the 20% discount, which happens if the Series A financing priced the company at, below, or slightly above the valuation cap.
For instance, if the price per share in the Series A financing is $1.00 per share, the SAFE converts into Series A preferred stock at $0.80 per share (due to the 20% discount). It would also receive a 1.25x liquidation preference (i.e., $1.00/share liquidation preference, but the SAFE converted at $0.80/share ($1.00/.80 = 1.25)).
Conversely, suppose the Series A valuation (e.g., $50M) is significantly higher than the valuation cap ($10M). The SAFE investor could receive a 5x liquidation preference when the SAFE converts into Series A preferred stock. Such a high liquidation preference is highly off-market in a Series A financing.
To avoid giving SAFE investors disproportionate liquidation preferences, founders should negotiate the SAFEs to include “shadow preferred stock” on conversion.
Shadow preferred stock gives the SAFE investor a separate series of preferred stock at conversion that matches the dollar amount investment on a 1:1 basis (without receiving a step-up related to the discount or valuation cap).
Anti-Dilution Protection
Anti-dilution protection is essential when a startup has a “down round” financing. A down round occurs when a subsequent round is at a lower valuation than the previous earlier round.
Anti-dilution protection benefits the earlier investors that invested at a higher valuation by adjusting the conversion price in which the preferred stock will convert into common stock to account for the valuation in the down-round financing.
The most common (and founder-friendly) version of anti-dilution protection is calculated using the “broad-based weighted average” formula to adjust the price the earlier investors paid for their shares to an appropriate average to account for the per-share price of the subsequent down-round financing.
Let’s go back to our example of the investor that purchased $1M of series seed preferred stock at a $10M valuation.
If the subsequent Series A financing priced the company at $5M, this would be a down-round (i.e., the seed valuation was higher than the Series A).
If the series seed preferred stock included broad-based weighted average anti-dilution protection (as customary), the seed round preferred stock will be adjusted somewhere between the price implied by the $10M seed valuation and the $5M Series A valuation.
Conversely, for the SAFE investor in a similar situation (e.g., seed round with a $10M valuation cap and a down-round Series A valuation of $5M), the SAFE will convert at a 20% discount based on the price implied by the down round financing (i.e., 20% discount on the $5M valuation).
This is significantly different than in the preferred stock seed round, where the price is adjusted somewhere between the $10M valuation and the $5M valuation; not below $5M as we have with the conversion of the SAFE.
Conclusion
Although many founders believe SAFEs and Convertible Notes are more efficient and inexpensive instruments for a seed round, that is not necessarily true considering the availability of standardized seed-stage preferred stock documents, such as those provided by Series Seed, and the unintended consequences caused by SAFEs and Convertible Notes.
For early-stage financing rounds (e.g., pre-seed and seed), SAFEs and Convertible Notes are often the investment instrument of choice for founders and funders alike.
SAFEs and Convertible Notes only include a few key terms (e.g., discount rate, valuation cap), making them easier to negotiate, and SAFEs, in particular, come in industry-accepted forms, such as those provided by YCombinator.
Although SAFEs and Convertible Note provide an efficient way to raise early-stage capital, many standard terms produce unanticipated results in later funding rounds. These consequences are beyond simply raising too much on a low valuation cap.
Many of these consequences, however, can be avoided by raising a priced round and issuing “series seed” preferred stock.
When founders hear “priced round” they tend to think of a Series A round, which is a fairly sophisticated and expensive round despite the adoption of industry-standard documents, such as those provided by the NVCA.
Generally, this is because Series A investors are investing a large enough amount of capital to warrant the negotiation of a whole bundle of economic and non-economic rights.
Even at the seed stage, however, it may be beneficial to raise a priced round rather than kick the valuation down the road and raise a round through SAFEs or Convertible Notes.
This is particularly true when an investor is willing to purchase equity and is relatively indifferent on terms other than the size of its investment, percentage ownership, liquidation preference, and anti-dilution protection.
To understand the economic consequences of raising a priced round v. a SAFE or Convertible Note round, let’s look at a company that is exploring two options for its seed round.
Although these investments appear to be equivalent at first glance, a deeper dive shows that is not the case.
The valuation cap and discount can give an investor significantly better rights when it comes to the liquidation preference and anti-dilution protection when the SAFE converts to preferred stock at a later round (e.g., Series A).
Liquidation Preference
A liquidation preference gives a preferred stockholder the right to receive at least the investment amount before the common stockholders receive any proceeds from a sale or liquidation of the company.
For instance, in our example, the preferred stock investor will receive a 1x liquidation preference on the $1M investment. If the company sells for $1M, the preferred stock investor would be entitled to all transaction proceeds.
However, in the SAFE example above, the investor may receive a liquidation preference that is greater than 1x the $1M investment.
When the SAFE converts (e.g., at the Series A financing), the investor will receive preferred stock, which will come with at least a 1x liquidation preference equal to the Series A price per share.
However, the SAFE investor will not pay the price per share of the Series A preferred stock because the SAFE will convert at a lower price (the lower of the conversion price of the discount or the valuation cap).
On conversion, the SAFE investor receiving preferred stock at a discount of the price paid by the Series A investors creates a situation in which the liquidation preference associated with the SAFE is greater than the amount the SAFE investor initially invested (i.e., the investor received a discount).
Conversely, the investor purchasing preferred stock at the “series seed” price round will have a dollar for dollar liquidation preference based on the amount invested without any discount. Remember, the investor invested $1M and received a 1x liquidation preference ($1M).
The benefit related to the liquidation preference received by the SAFE investor is relatively minor if the SAFE’s conversion price is based on the 20% discount, which happens if the Series A financing priced the company at, below, or slightly above the valuation cap.
For instance, if the price per share in the Series A financing is $1.00 per share, the SAFE converts into Series A preferred stock at $0.80 per share (due to the 20% discount). It would also receive a 1.25x liquidation preference (i.e., $1.00/share liquidation preference, but the SAFE converted at $0.80/share ($1.00/.80 = 1.25)).
Conversely, suppose the Series A valuation (e.g., $50M) is significantly higher than the valuation cap ($10M). The SAFE investor could receive a 5x liquidation preference when the SAFE converts into Series A preferred stock. Such a high liquidation preference is highly off-market in a Series A financing.
To avoid giving SAFE investors disproportionate liquidation preferences, founders should negotiate the SAFEs to include “shadow preferred stock” on conversion.
Shadow preferred stock gives the SAFE investor a separate series of preferred stock at conversion that matches the dollar amount investment on a 1:1 basis (without receiving a step-up related to the discount or valuation cap).
Anti-Dilution Protection
Anti-dilution protection is essential when a startup has a “down round” financing. A down round occurs when a subsequent round is at a lower valuation than the previous earlier round.
Anti-dilution protection benefits the earlier investors that invested at a higher valuation by adjusting the conversion price in which the preferred stock will convert into common stock to account for the valuation in the down-round financing.
The most common (and founder-friendly) version of anti-dilution protection is calculated using the “broad-based weighted average” formula to adjust the price the earlier investors paid for their shares to an appropriate average to account for the per-share price of the subsequent down-round financing.
Let’s go back to our example of the investor that purchased $1M of series seed preferred stock at a $10M valuation.
If the subsequent Series A financing priced the company at $5M, this would be a down-round (i.e., the seed valuation was higher than the Series A).
If the series seed preferred stock included broad-based weighted average anti-dilution protection (as customary), the seed round preferred stock will be adjusted somewhere between the price implied by the $10M seed valuation and the $5M Series A valuation.
Conversely, for the SAFE investor in a similar situation (e.g., seed round with a $10M valuation cap and a down-round Series A valuation of $5M), the SAFE will convert at a 20% discount based on the price implied by the down round financing (i.e., 20% discount on the $5M valuation).
This is significantly different than in the preferred stock seed round, where the price is adjusted somewhere between the $10M valuation and the $5M valuation; not below $5M as we have with the conversion of the SAFE.
Conclusion
Although many founders believe SAFEs and Convertible Notes are more efficient and inexpensive instruments for a seed round, that is not necessarily true considering the availability of standardized seed-stage preferred stock documents, such as those provided by Series Seed, and the unintended consequences caused by SAFEs and Convertible Notes.
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