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Intuition - Part 1/4: How does a Post-SAFE convert?

Posted by  Rajesh Gopi   on April 07 2022

 

Introduction

There's a lot of confusion amongst founders wanting to understand how a Convertible Note, Pre-SAFE, and Post-SAFE impact dilution.

 

Post-SAFE ≠ Convertible Note

 

 

Founders incorrectly assume that Post-SAFE and Convertible Notes behave similarly.

 

Since investors can request either a NOTE or a SAFE vehicle, it's imperative for founders to understand the differences and their impact to founder dilution.

 

The best way to understand the differences is by looking at some numeric examples.

 

For ease of understanding, I've broken this topic into 4 parts.

 

Part 1: How does a Post-SAFE convert? (this article)

 

Part 2: How does a NOTE convert?

 

Part 3: How to make a NOTE and Post-SAFE economically behave the same?

 

Part 4: Do NOTE and Pre-SAFE behave the same?

 

Note that this series is to help founders understand the intuition behind how these instruments convert in a priced round. 

 

The scenario described is very limited in nature, but should provide enough context to extrapolate to other scenarios. 

 

Geek Alert: This series of articles are numeric in nature.

 

 

Setup: An example cap table

We will use the same cap table scenario for all 4 parts.

 

Cap Table

 

Founders 3M shares
Options 1M shares
Fully Diluted 4M shares

 

Post-SAFE

Valuation Cap $6M
Discount 20%
Investment $100K

 

Priced Round

Pre-Money Valuation $8M
PPS $8M / 4M = $2.00

 

 

How does a Post-SAFE convert? 

The standard YC Post-SAFE document does not have a Valuation Cap & Discount combination. At TWO12, we see this variant all the time. In these articles, we'll assume there's both a cap and discount on the SAFE to cover both scenarios.

 

Similar to a Convertible Note, a Post-SAFE gives the investor better terms between a Cap and a Discount - whichever results in more equity. It is not discount in addition to the cap.

 

The steps to understand Post-SAFE conversion are:

 

a) Determine the number of shares a discount will offer

b) Determine the number of shares a valuation cap will offer

c) Pick the better of the two that gives more ownership to the investor

 

 

It is important to understand that the primary distinction between a Note and a Post-SAFE is that a Post-SAFE converts on the post-conversion fully diluted shares.

 

 

 

When does the Valuation Cap on a Post-SAFE win?

From a high level, this is a 2-step process.

 

Step 1: Compute the number of shares the Post-SAFE investor gets if the discount is applied.

 

Determine the PPS if discount is hit $2.00 * (1 - 20%) = $1.60
Compute the number of shares this PPS gets $100K / $1.60 = 62,500 shares

 

 

Step 2: Compute the number of shares the Post-SAFE investor gets if the cap is applied.

 

For this, we first determine the ownership interest the Post-SAFE investor gets on conversion.

 

Post-SAFE Ownership at Priced

(before dilution)

$100K / $6M = 1.667%

 

 

Next calculate the number of shares that will be issued to the Post-SAFE investor.

 

1.667% x (4M + x) = x

x = 67,797 shares

 

 

That's it.

 

We can see that the Valuation Cap in this example gives the Post-SAFE investor more shares. So, the Post-SAFE uses the cap instead of the discount.

 

The effective PPS of the Post-SAFE can also be quickly calculated.

 

Effective Post-SAFE PPS

$100K / 67,797 = $1.475

 

 

 

When does the discount on a Post-SAFE win?

Now, let's look at another scenario where the deal structure is exactly the same, except that the Post-SAFE has a 30% discount.

 

Post-SAFE

Valuation Cap $6M
Discount 30%
Investment $100K

 

 

In this case, the shares received by the Post-SAFE investor will be:

 

Determine the PPS if discount is hit $2.00 x (1 - 30%) = $1.40
Compute the number of shares this PPS gets $100K / $1.40 = 71,429 shares

 

 

This is more than the shares that the valuation cap would issue to the investor (67,797), so the Discount version gets picked.

 

 

Does Post-SAFE's valuation cap always get hit if priced round is at a higher valuation?

NO.

 

I have seen bizarre behavior from founders who offer 90% discount on a capped NOTE and SAFE. The incorrect understanding here is that these founders think that they will surely raise the priced round at a higher valuation that only the cap on the NOTE or SAFE will hit. Such deals on a cap table pretty much tell the world that the startup is uninvestable.

 

 

How can TWO12 help?

The example presented in this article is a simple scenario. Cap tables are usually much more complex with multiple NOTEs and SAFEs stacked with different caps and discounts. Spreadsheets will fail you.

 

Join TWO12's list of growing companies and use the power of our modeling engine to determine founder dilution accurately.

 

Topics: cap table, startup, Founder Tool, dilution, Post-SAFE, Post-SAFE conversion math