Unsafe Cap Tables

Recently, I’ve had to model the cap tables of a couple of startups looking for their next round of funding. Not all investors do this, and even fewer founders think about it. However, the structure of the cap table has fundamental effects on future options for financing and, therefore, the risk that investors are taking now. This post will go deep into the math to spotlight what investors look out for, and how founders should think about their earliest rounds. If you hate Math, look for the callouts. If you need it, there’s a Glossary at the end.

It is part of my business to help founders with fundraising and – often – the recapitalization that has to happen to make it possible. If you need help, contact me through the website and let’s chat.

As discussed in UNSAFE and SAFE Gotcha, SAFE instruments have some significant downsides. Here, we’re going to look at how they affect your first priced round. Buckle up - this is a discussion only a CFO will love!

Let’s start with some basic definitions. A SAFE is a contract, not a security. Essentially all SAFEs today are “post money.” This is due to poor outcomes for investors with “stacked” pre-money instruments. SAFEs were originally envisaged as a one-time method to raise capital to build toward a “real” round. Today, though, startups may raise multiple times, using a number of SAFEs - each with different terms - over the initial phases of the company. Such a stack of SAFEs using the old “pre money” terms creates some complex calculations on conversion and significant risk for investors. The post-money terms move this risk to the founders.

Before we dive in, we need to structure things and define a few terms. A lot of confusion and circular calculations will be avoided by doing so. The key is to understand that the SAFEs are converted immediately before the consummation of the priced round, not as part of the priced round. They are “post money” only in this context and not in the context of the conversion. It is much more accurate to call them “post conversion”. As we go through the calculations below, there are three timeframes: before the conversion (BC), after the conversion but before the round (BR), and after the round (AR). And remember, since SAFEs are contracts, they are not part of the capitalization of the company BC.

Assume that the number of fully diluted shares BC is “FD” (in shares) and that new money coming in is “NM” (in dollars). The round will be done with a pre-money (that is, BR) valuation of V.

One other introductory point: the calculations need to be conducted using the number of shares, with price/share used to convert to/from dollars. While it’s possible to work in the dollars domain, things get (even more) incomprehensible rapidly. Now let’s calculate. We can do this the (sort of) easy way or the hard way. The former gets you to an answer more quickly; the latter is better if you will be building a spreadsheet to model multiple scenarios.

The Easy Way

Some simple stipulations:

• The SAFEs are all post-money. All discounts are the same. (Not required, but preferred in this method.)

• You know how much NM will be. (Not required, but preferred in this method.)

Step 1: Price per share (PPS) of the round = V / FD.

Step 2: The discounted PPS = DF*PPS (where DF is the Discount Factor = 1-discount).

Step 3: For each SAFE tranche, divide its CAP by FD. The SAFE Share Price (SSP) for that SAFE is the minimum of Steps #2 and #3.

Step 4: For each SAFE tranche, divide the amount invested by its CAP to get Safe percentage (s%). Total the s% to get the total SAFE percentage (S%).

Step 5: Calculate the new money percentage (NM%) = NM / (V+NM).

Step 6: Note that NM% and S% are fixed post-money percentages. The current Common plus any option pool top-up are in the rest. Therefore, the total number of shares after the transaction (fully diluted post, or FDp) will be FD / (1-S%-NM%).

Step 7: Calculate…
NM% * FDp = New Money Shares (NMS). Multiply by PPS to get back to NM. (Proof left to the reader. Remember, this is the easy way.)

Per tranche of SAFEs, calculate the amount invested / SSP to get the number of shares. Note that if V is below the CAP, this will issue more shares than s% calculated in Step #4. This is how risk is transferred from investors to the founders in a post-money SAFE.

Step 8: Done!

The Hard Way

Let’s start simply. A company raised using one or more uncapped SAFEs and no discount. (I question the sophistication of anyone who invests under those terms, but we have to start somewhere.) When the priced round happens, first, the SAFEs convert (we are moving from BC to BR).  For convertible notes, the share price is very simple: it’s V / FD.  Done. Maybe multiply by a discount. Anyway, have a nice day.

And that’s also true of the old pre money SAFEs. But for post money SAFEs, the denominator includes the shares from the converted SAFEs, so the SAFE Share Price (SSP) is V / (FD + SAFE Shares (SS)). That then leads to a circular calculation: the number of shares depends on the share price depends on the number of shares.  Argh!

The solution to the paradox is to calculate on a different path. First, calculate the number of shares. For a post money SAFE, this is SAFE Shares (SS) = Total Shares (TS) * the SAFE-invested Old Money (OM)/V. So
SS = TS * OM/V
But TS = FD + SS. So
TS = FD + TS * OM/V —> FD = TS (1 – OM/V) —> TS = FD / (1 – OM/V)
That makes sense when you think about it but, to be honest, percentages were my one weak spot in 6th Grade Mathematics. (Shout out to Mr. Bobbins, and my rival for #1 in that class, Kelly H.)

So, we now have what we need. Let’s temporarily define SAFE Percentage (S%) = OM/V. The factor (1-S%) is the special sauce you need for the rest!
Thus:
SAFE Share Price (SSP) = V / TS = V * (1-S%) / FD
SS = OM/SSP = FD * OM / V / (1-S%)
Essentially, S% acts as a discount on the pre-money valuation of the deal. We will come back to this below.

SAFE Terms

Having solved the basic formula, we can now look at SAFE terms.  First, how does a Discount work? It’s pretty easy to understand. The discount reduces the price of SAFE Shares. It’s common to define “1-discount” as the Discount Factor (DF), so
S% = OM / (DF*V) (redefined)
SSP = DF * V*(1-S%)/FD
It’s not just a simple discount on the valuation. In fact, the discount acts twice to lower the SAFE Share Price (and therefore increase the number of shares that investors get).

What about a cap? As we will soon see, a cap is not a valuation. I put this in bold, and repeat it, because failing to understand this can lead to a lot of founder dissatisfaction. If there’s no discount, then:
S% = OM / min(V, CAP) (redefined again)
SSP = min(V, CAP) * (1-S%)/FD

The “min” is the minimum of the values, to ensure investors get the most shares (per the SAFE terms). If the pre-money valuation of the round is below the cap, investors get the normal SAFE discount as discussed above. If the pre-money is above the cap, and the investors pay at the cap (hence the name) and are not diluted by the high share price paid by new money. In fact, if you raise above the cap, investors get the same percentage of the company regardless of the valuation:
S% = OM/CAP
Note that S% is thus defined only by constants OM and CAP. Which brings us to an…

Important Point
When investors look at the capitalization of a company, they do a quick calculation of OM/CAP to know how much of the company has “already been sold.” That tells them how much the founders equity truly have and if, after it’s diluted in the round, there will be enough left to keep the founders motivated. If not, it’s a “busted cap table” and a quick pass. Founders are sometimes deceived by the “simple” of SAFEs and finance things for too long by issuing ever more of them. And then they find it impossible to raise a priced round.  This is why.

You may think I am exaggerating.  However, I have seen companies where OM/CAP > 40% and I have done the cap table modeling of ones above 30%. When it comes to raising new money, it’s… constraining.  Be warned.

Moving on, let’s look at a valuation below the cap. After the conversion, there are FD+OM/SSP shares and the SAFE holders own
S% = OM/SSP / (OM/SSP + FD)
OM and FD are fixed; only SSP changes. SSP covaries with valuation and as valuation goes down, OM/SSP goes up and the above fraction approaches 1… or S%=100%.

Important point
When you raise below the cap of a SAFE, the SAFE investors get a higher percentage of the outcome. This is the “reward” investors get for having taken the risk in the first place, and the penalty founders face because the company has not performed as expected. Said another way, a measure of the risk has been moved from investors to founders. This is not how it works for “complex” securities which have a true valuation. Again, a SAFE cap is not a valuation!

The full SAFE terms

What happens if there is a discount and a cap? If you’ve been reading so far (thank you), it should be clear that:
S% = OM / min(DF*V, CAP) (final definition) and
SSP = min(DF*V, CAP) * (1-S%)/FD and
SS = OM / SSP
That tells you how to structure your spreadsheet. First, calculate S%, with all variables known. Then calculate the price per share SAFE holders will pay. Then calculate how many shares the SAFE holders get. And then you can calculate the price per share for the new money: V / (SS+FD). Now go close the deal!!

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But… what if you have a whole pile of SAFEs with different terms? The Math is actually easy, but the notation is not. Rather than use Σ and subscripts, I will describe the process:

1.       For each tranche of SAFEs, calculate per-tranche s% using the tranche’s terms and investment.

2.       Sum the per-tranche s% values from Step #1 to create S%.

3.       For each tranche, calculate its SSP using its terms and S% from Step #2.

4.       For each tranche, calculate the SAFE Shares (per-tranche ss).

5.       Sum the ss values from Step #4 to create SS.

6.       Calculate the price for the new money using SS from Step #5.

7.       Close the deal.

You have finally arrived AR!

Summary

As we’ve seen, SAFEs are anything but simple when it comes to calculating their conversion. I hope you benefit from the – literal – days I have spent fighting with spreadsheets to make these models work. If you found this useful, please ping me through the site!

This is some of what I do for my clients. If you have a company I should be helping, please contact me through the website!

Note
Note that a SAFE with a discount and a cap transitions from the former to the latter when
V = CAP/DF.
That is, such a SAFE is actually capped at a higher amount due to the “most shares” terms. The math is left as an exercise for the reader.

Glossary

BC - the status of the cap table “before conversion” of any SAFEs.
BR - the status of the cap table after the conversion of the SAFEs but “before the round” of new equity.
AR - the status of the cap table “after the round” is closed.

FD - the number of “fully diluted” shares of stock in BC. Denoted in shares.
V – the pre-money valuation of the company. That is, the valuation in BC and BR.
OM – the money that SAFE investors invested, i.e., old money.
NM – the new money coming in through the priced round, denoted in dollars.

CAP – the SAFE cap.
DF – the SAFE discount factor, which equals 1-discount.
SS – Shares issued in the conversion of SAFEs to equity.
S% - Percentage of total equity held by the SAFE holders (BC).
SSP – SAFE share price during the conversion.

Examples

(Using round numbers. Not a real scenario. Your numbers will vary.)
Suppose you raise $1M on a $10M cap SAFE. You work for a while and then want to do a Seed Round: $2M priced. Also assume there are 2M shares of fully diluted Common.

Suppose things have gone well and the price is $12.5M pre (i.e., above the cap). So:
S% = $1M / $10M = 10%
SSP =  $10M * (1-10%) / 2M shares = $4.50/share
SS = $1M / $4.50/share = 222,222 shares
The new money gets a price per share of $12.5M / 2,222,222 shares = $5.40/share, so they get 370,370 shares.  Post money, then, we see the following stakes:

You’ve done well.  Because you executed well enough to raise above the cap, you were diluted a mere 23% despite raising all of that cash!

Now suppose the other case. Things did not good quite as well as planned… not bad, but not good enough. So, you want to raise that $2M at $8M pre. Let’s do the math:
S% = $1M / $8M = 12.5%
SSP = $8M * (1-12.5%) / 2M shares = $3.50/share
SS = $1M / $3.50/share = 285,714 shares
The new money comes in at $8M / 2,285,714 shares = $3.50/share, so they get 571,429 shares. Post money, then, we have:

To further the point, assume you’re desperate, but have somehow found someone to give you $2M at $5M pre. Unlikely, but let’s just do the math.
S% = $1M / $5M = 20.0%
SSP = $5M * (1-20.0) / 2M shares = $2.00/share
SS = $1M / $2.00/share = 500,000 shares
The new money comes in at $5M / 2,500,000 shares = $2.00/share, so they get 1M shares. Post money, then, we have:

You kept control of the company! (I did not expect that when I picked the numbers, to be honest.)

Now let’s do the same three scenarios, but changing the assumed SAFE raise to $3M (still on a $10M cap). Then we get…

Suppose things have gone well and the price is $12.5M pre (i.e., above the cap). So:
S% = $3M / $10M = 30%
SSP =  $10M * (1-30%) / 2M shares = $3.50/share
SS = $3M / $3.50/share = 857,143 shares
The new money gets a price per share of $12.5M / 2,857,143 shares = $4.375/share, so they get 457,143 shares.  Post money, then, we see the following stakes:

You’ve done well still. Now suppose the other case: you want to raise that $2M at $8M pre. Let’s do the math:
S% = $3M / $8M = 37.5%
SSP = $8M * (1-37.5%) / 2M shares = $2.50/share
SS = $3M / $2.50/share = 1,200,000 shares
The new money comes in at $8M / 3,200,000 shares = $2.50/share, so they get 800,000 shares. Post money, then, we have:

As expected, it’s not a pretty picture.