In the dynamic and ever-evolving world of startup financing, founders face crucial decisions that can significantly impact their ownership stakes and the control they have over their ventures. One of these critical choices is the selection of pre-money or post-money Simple Agreement for Future Equity (SAFE) instruments.
In this article, we’ll explore the nuances of these SAFEs and make a compelling case for why choosing pre-money valuation caps is a more founder-friendly financing strategy.
The key distinction
Pre-money and post-money SAFEs may sound deceptively similar, but they have distinct implications for ownership dynamics. Let’s dive into the key difference between the two:
Pre-Money SAFEs: When opting for a pre-money SAFE, the valuation cap is applied before the investment, determining the investor’s stake based on the company’s valuation before their investment.
Post-Money SAFEs: In contrast, post-money SAFEs apply the valuation cap after the investment has been made. This seemingly subtle difference can lead to significant discrepancies in ownership percentages, directly affecting founders.
A tale of two investors
To illustrate the profound impact of these SAFEs, let’s consider a scenario involving two investors:
Investor 1: Injects US$1 million into your startup through a post-money SAFE with a valuation cap of US$10 million, resulting in a 10 per cent ownership stake.
Investor 2: Contributes US$3 million with a higher post-money valuation cap of US$15 million, resulting in a 20 per cent ownership stake.
The crucial point here is that when these SAFEs convert to shares during a priced round, your ownership as a founder gets diluted by a staggering 30 per cent (10 per cent from Investor 1 + 20 per cent from Investor 2).
Understanding the dilution
With post-money SAFEs, the risk of diluted ownership in future funding rounds is significantly higher. It’s essential to grasp this key concept: each investor gets a fixed ownership percentage, and when SAFEs transition to shares during the priced round, the dilution from other SAFE investors primarily impacts only the founder’s remaining portion.
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Choosing a pre-money SAFE
Now, let’s revisit the same scenario with pre-money valuation caps of US$9 million for Investor 1 and US$12 million for Investor 2. The dilution for founders drops from 30 per cent to 28 per cent, resulting in the following ownership distribution:
- Founder: 72.0 per cent
- Investor 1: 8.0 per cent
- Investor 2: 20.0 per cent
Each SAFE note mathematically interacts with others, mitigating the impact on founders’ equity. The result is a more favourable ownership structure for the founders.
The recommendation
Given these considerations, the recommendation for founders is clear: opt for a pre-money valuation cap over a post-money one. By doing so, you’re not only preserving your ownership stake but also ensuring a more equitable distribution of equity in your startup.
The nuances of pre-money SAFEs
Now that we’ve established the importance of pre-money valuation caps, let’s delve deeper into the nuances of using pre-money SAFEs for your startup financing.
Valuation cap calculation
In a pre-money SAFE, the valuation cap is determined before the investor’s contribution. This approach anchors the investor’s ownership stake to the valuation of the company at the time of their investment. As a founder, this can work in your favour, as you are less susceptible to dilution caused by subsequent investments at higher valuations.
Mitigating dilution
Pre-money SAFEs naturally provide more protection against dilution. Since the valuation cap is established beforehand, founders can maintain a more significant portion of their ownership when subsequent rounds of funding occur. This means that you retain more control over your startup and can preserve your vision for the company.
Investor attraction
Interestingly, pre-money SAFEs may also attract investors who prefer a more founder-friendly structure. Investors may appreciate the fairness of pre-money valuation caps and the reduced risk of future dilution. This alignment of interests can lead to more fruitful partnerships and a more stable foundation for your startup’s growth.
Fundraising flexibility
Pre-money SAFEs offer founders greater flexibility when it comes to raising capital. By setting a pre-money valuation cap, you can establish clear terms for investment rounds, making negotiations with potential investors more straightforward. This transparency can streamline the fundraising process and help you secure the right partnerships for your startup’s success.
Enhanced control
Opting for pre-money SAFEs not only protects your ownership but also safeguards your control over the company. As a founder, maintaining control of your startup’s direction and decision-making processes is essential. Pre-money SAFEs support this by minimising the dilution of your equity and allowing you to steer your company with a firmer grip on the wheel.
Also Read: 5 fundraising tips for first-time founders
The pitfalls of post-money SAFEs
To fully appreciate the advantages of pre-money SAFEs, it’s essential to understand the pitfalls of post-money SAFEs and why they may not be the best choice for founders.
High dilution risk
Post-money SAFEs expose founders to higher dilution risks, as demonstrated in the earlier scenario. With fixed ownership percentages for investors, any subsequent investments at higher valuations will primarily dilute the founder’s stake. This can erode your control and influence over your own company.
Founder’s vision at risk
A significant consequence of high dilution is that it puts your vision for the company at risk. As your ownership decreases, you may find it increasingly challenging to make strategic decisions and execute your plans as intended. Protecting your ownership stake with pre-money SAFEs can help you maintain your vision and drive your startup’s success.
Investor preferences
Investors choosing post-money SAFEs may have different motivations and interests that may not align with those of the founders. Their primary concern may be maximising their return on investment, potentially leading to conflicts in decision-making and overall company direction.
Funding negotiations complexity
The complexity of post-money SAFEs can sometimes lead to protracted and challenging negotiations during fundraising rounds. The uncertainty regarding ownership percentages in subsequent funding rounds can complicate discussions and potentially discourage investors.
Conclusion
In the world of startup financing, the choice between pre-money and post-money SAFEs is a crucial decision that founders must make.
While both options have their merits, pre-money valuation caps stand out as the more founder-friendly choice. They offer protection against dilution, attract like-minded investors, provide flexibility in fundraising, and safeguard founder control and vision.
Founders who prioritise maintaining ownership and control over their ventures should consider the benefits of pre-money SAFEs. By choosing this financing strategy, you can not only protect your interests but also build a more equitable and secure foundation for your startup’s journey to success.
In a landscape where informed decisions make all the difference, pre-money SAFEs empower founders to chart a course for their startups that aligns with their vision and aspirations.
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