Be Careful with Convertibles: Your SAFE May Hurt You
- Lighter Capital
- Apr 8, 2019
- 7 min read
Updated: Oct 1
Convertible notes and convertible equity instruments, like Simple Agreement for Future Equity (SAFE), are supposed to be simple, straightforward and not complex. After all, they are only a handful of pages in length, right? Well, watch out.
If you are a startup founder or CEO considering using a convertible note, a SAFE, or another type of convertible instrument; there is a little-known aspect of convertibles that can cost you a lot in equity dilution: the denominator. More specifically, the number of shares included in the denominator when the SAFE converts.
How many company shares are there at conversion?
SAFE conversion is triggered when a startup raises a priced equity round—like a Series A—at which a company valuation is determined and preferred stock is usually issued to new investors.
It's the number of shares, often referred to as the company's capitalization, that can dramatically shrink your ownership value.
For startups and private companies, "capitalization" usually refers to the capitalization table, which gives a detailed breakdown of who owns what percentage of the company.
The conversion price per share at the trigger event will depend on the total number of shares or capitalization. To calculate conversion price per share you divide the valuation cap by total number of shares. But how do you figure out the capitalization?
This is where the specifics in your SAFE matter—they determine the capitalization and conversion price per share. It's good to stay on top of capitalization in general, because it helps you keep track of your own equity and avoid surprise dilution when you raise money.
1. Is there a discount or valuation cap?
If there's a valuation cap and a discount in the SAFE agreement, the first step is to figure out which will be used at the time of conversion. Usually, the investor gets the better deal of the two.
Valuation Cap: If there’s a cap, the SAFE converts at the lower of (1) the cap-based price or (2) the actual round’s share price.
Discount: If there’s a discount, the SAFE investor might instead get shares at, say, a 20% cheaper price than the new investors.
In this example we'll use the valuation cap.
2. Is there preferred stock?
SAFE investor shares almost always convert into the same class of preferred stock that's sold in that round to reward early investors for assuming the risk. So, while new investors are paying the full Series A price, SAFE holders may effectively be buying in at a cheaper price per share (via the cap or discount).
Why preferred stock matters
By converting into the same preferred class as the priced round, SAFE investors get aligned with the new VC investors instead of being stuck with common stock. Preferred stock usually comes with perks like:
Liquidation preference (they get paid back before common stockholders in a sale)
Voting rights
Anti-dilution protections or dividends
Provisions in your SAFE will tell you how shares are divvied up, for example:
All issued and outstanding securities on an as-converted to common stock basis. This would include issued and outstanding stock options (but not unissued shares reserved in the option pool), warrants, etc. (although theoretically you could only include exercisable options if you defined it this way).
All issued and outstanding securities on an as-converted to common stock basis, including the entire pool of shares reserved under the existing option plan.
All issued and outstanding securities on an as-converted to common stock basis, including the entire pool of reserved shares under the existing option plan and as increased in the equity financing.
The dilution impact on founders will vary with subtle verbiage changes, and the difference in dilution can be dramatic. The first scenario above is the most founder friendly, and the third is the most investor friendly; the second is the middle ground.
Language to Watch Out For in Your SAFE or Convertible Note
One form of convertible note, which is commonly used, says the following (this is the worst for startup founders):
Conversion upon a Qualified Financing. In the event that the Company issues and sells shares of its capital stock to investors (the “Investors”) on or before the date of the repayment in full of this Note in an arms-length equity financing resulting in gross proceeds to the Company of at least $250,000 (excluding the conversion of this Note or convertible securities issued for capital raising purposes (e.g., Simple Agreements for Future Equity)) (a “Qualified Financing”), then the outstanding principal balance of this Note and any unpaid accrued interest shall automatically convert in whole without any further action by the Holder into such shares sold in the Qualified Financing at a conversion price equal to the lesser of (i) 80% of the price paid per share for such shares by the Investors, or (ii) the price (the “Cap Conversion Price”) equal to the quotient of $3,000,000 divided by the total number of outstanding shares of the Company immediately prior to the Qualified Financing calculated on a fully diluted basis (assuming conversion of all convertible securities and exercise of all outstanding options, warrants, phantom stock, stock appreciation rights, and other rights to acquire capital stock of the Company, including any shares reserved and available for future grant under any equity incentive or similar plan of the Company, and/or any equity incentive or similar plan to be created or increased in connection with the Qualified Financing, but excluding shares issuable upon the conversion of the Note(s) or any other current or future convertible debt or equity instruments issued for capital raising purposes (e.g., Simple Agreements for Future Equity)).
For startup founders, these instruments should not include the bolded provision above, as it significantly impacts the valuation cap denominator in ways you may not have expected at issuance of the convertible instrument. Instead, a founder-friendly way to structure the document is something like this:
Conversion upon a Qualified Financing. In the event that the Company issues and sells shares of its capital stock to investors (the “Investors”) on or before the date of the repayment in full of this Note in an arms-length equity financing resulting in gross proceeds to the Company of at least $250,000 (excluding the conversion of this Note or convertible securities issued for capital raising purposes (e.g., Simple Agreements for Future Equity)) (a “Qualified Financing”), then the outstanding principal balance of this Note and any unpaid accrued interest shall automatically convert in whole without any further action by the Holder into such shares sold in the Qualified Financing at a conversion price equal to the lesser of (i) 80% of the price paid per share for such shares by the Investors, or (ii) the price (the “Cap Conversion Price”) equal to the quotient of $3,000,000 divided by the total number of outstanding shares of the Company immediately prior to the Qualified Financing calculated on a fully diluted basis (assuming conversion of all convertible securities and exercise of all outstanding options, warrants, phantom stock, stock appreciation rights, and other rights to acquire capital stock of the Company, but excluding shares issuable upon the conversion of the Note(s) or any other current or future convertible debt or equity instruments issued for capital raising purposes (e.g., Simple Agreements for Future Equity)).
Y Combinator’s Simple Agreement for Future Equity (SAFE)
Interestingly enough, in Y Combinator’s SAFE (which is essentially a convertible note without the debt or interest component), YC cuts a middle path. They include the unissued option pool, but they specifically exclude “any increases to the Unissued Option Pool (except to the extent necessary to cover Promised Options that exceed the Unissued Option Pool) in connection with the Equity Financing.”
This methodology strikes a balance between the two scenarios above, in cases where option pools associated with financings are captured in the conversion calculation by the SAFE. Typically a convertible instrument will utilize the size of option pool prior to any increase in connection with a financing, rendering this language inapplicable, but there are some financing formulations where pools increased in connection with financings would be implicated, and in those cases this serves as a great protection to founders.
However, this new SAFE formulation is still not as startup founder friendly as omitting the option pool all together.
Example: Calculate SAFE Price per Share
Let's assume the following:
You and your co-founders own 2M shares in the aggregate.
You have set aside 300,000 shares in your equity incentive plan.
You raise $500,000 in convertible debt or equity with a valuation cap of $3M and a 15% discount.
You then raise a $5M Series A at a $12M pre-money valuation.
Before your closing of your Series A Round, let’s say you have issued 115,000 options, leaving 185,000 shares available under the plan.
Your investors require, as a condition to closing the investment, that you increase your available stock option pool reserve by 100,000 shares, to a total of 285,000 shares available in the pool.
If you had the founder friendly document, the price per share would be $3,000,000/2,115,000, or $1.41843972.
(By the way, in this example, the price per share paid by the new investors would be $12,000,000/(2,000,000+115,000+285,000), or $5.00 a share.)
If you had the investor friendly document, the per share would be $3,000,000/(2,000,000+115,000+285,000), or a price per share of $1.25 a shares.
If your document utilizes the Y Combinator middle of the road approach, then the price per share would be $3,000,000/(2,000,000+300,000), or $1.30. Not as good as the founder friendly version, but not as bad as the investor friendly version.
The variation in the denominator language results in the convertible note holders getting a lot more shares, diluting the founders of a startup.
Depending on the size of your pool and the valuation cap at play, this difference could be even more pronounced. It is not uncommon for companies to raise notes initially at fairly low valuation caps, and for those caps to increase in size as the round continues. Very early note holders with low valuation caps can wind up getting a screaming deal.
Key Takeaways
The key here is to recognize the various inputs that come into play in terms of converting your convertible interests, and plan your cap structure strategy accordingly to minimize the unforeseen impact that these potentially small tweaks in legal language may have.
When you are converting at a cap, the result is always better for founders if the denominator is smaller. The bigger the denominator the lower the price per share and the more shares the convertible securities holders receive on a conversion.
