Today’s Menu ☕️

• NYC Tech Breakfast Club Thursday July 25th

• SF Tech Breakfast Club August 15th

• Austin Tech Breakfast Club September 24th

• A brief history of SAFEs

👋 Hi, Breakfast Club Members!

Thank you to Alex Kearns and Citizens for sponsoring today’s newsletter - scroll down to learn more

Shoutout to all the VC’s who are actually working this summer. I love you.

Pumped to see the crew on Thursday in NYC for Tech Breakfast Club. Cohosting with the delightfully unhinged Pavel Asparouhov

I received a couple questions this week about pre money SAFEs so I’m going to give a brief history of SAFEs (scroll down)

If you’re a founder raising a preseed or seed round and want to learn more about SAFE mechanics and how you can tweak SAFEs, reply to this email - we should chat

And if you’re forming a company - let me know and I’ll hook you up with the Tech Breakfast Club discount for Clerky formations.

Tech Breakfast Club Events

New York Tech Breakfast Club July 25th (THIS THURSDAY)

SF Tech Breakfast Club August 15th
Cohosting with NYC Tech Breakfast Club OG Jonathan Baer. We’re celebrating Jonathan getting into YC. I wrote about Jonathan a couple months back when he just started his company (now rebranded as Overlap) - if you want to read that interview click here 

Austin Tech Breakfast Club September 24th
We’re going back to Austin! If you want to get involved or partner with Tech Breakfast Club, reply to this newsletter and let’s chat!

Tech Breakfast 🤝 Citizens

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Legal Stuff
Brief (Well Not That Brief) History of SAFEs

There are few markets that evolve faster than the world of startups, for unsurprising reasons. 

First, a brief history:

1990s – Long before the term “pre-seed” was even a thing, before the SaaS revolution made it even conceivable to start building a tech company with only a few hundred thousand dollars (or less), almost all early startup funding occurred as a complex preferred stock round; what now is reserved for Series A and larger seed rounds. It was a very different world from today.

Early 2000s  – Then convertible notes, once reserved mostly for “bridge” rounds in between preferred stock financings, started being used for seed funding; a natural evolution for rounds that were getting smaller and couldn’t justify full equity round negotiation time or costs. It worked relatively well. We also saw in this era the emergence of “series seed” preferred stock templates, a slimmed-down version of the more complex NVCA, that allowed you to raise a seed equity round for about 40-50% less in legal fees. These also got a decent amount of traction.

2013 – Then the Pre-Money SAFE, which is a convertible note without interest or maturity (effectively) was released around 2013. Founders started (candidly) abusing that instrument by raising Pre-Money SAFEs for years and years while obscuring the real economics behind what angel investors were funding. This was do-able because if your second, third, or fourth SAFE round has a pre-money valuation cap, but nothing capping the post–money, your newest investors can’t really know what % of the company their investment is buying without making you model out all the conversion math.

They could, for example, be putting in $1 million at a $49 million pre-money cap, which would suggest a $50 million post-money valuation, but they were in fact getting way less than 2% of the business because numerous unmodeled earlier SAFE rounds were pushing up the post-money. The post-money valuation is what really hardens a startup investor’s ownership percentage.

2018 – In late 2018 Y Combinator released the Post-Money SAFE. It flipped the economics of SAFEs to have a post-money cap, making the % purchased by investors far more transparent and immune to this issue of companies obscuring a deal’s economics. This was a good development, and the Post-Money model of valuation caps has since gained substantial market share.

But there’s one very big problem. The solution YC devised went much further – to the benefit of investors (including themselves) –  than was necessary to let investors know what % of the cap table they are buying on the day they invest. It further promised those investors complete non-dilutability of that percentage until the SAFE converts, including through subsequent SAFE rounds with higher valuation caps. This makes the Post-Money SAFE far harsher economically (to founders) than any other instrument in the history of startup finance.

YC itself has made an enormous amount of money by implementing this new math into the deal it gets with its own accelerator’s startups. I’ve seen YC companies start with giving 7% (the usual deal) to YC, but by the time the SAFE actually converts, after two or three more convertible rounds, the YC % is functionally equivalent to having received 10% or more years earlier. The smartest YC companies get ahead of this issue and raise a seed equity round as soon as they can after exiting the accelerator, cutting off this problem by converting all their SAFEs, but most don’t. It ends up costing them dearly.

That’s the history.

2024 – Today, pre-seed and seed rounds have evolved such that you very rarely see an equity round that is smaller than $3-5 million. Many companies raise more than $5-10 million as convertibles (SAFEs or Notes) before doing an equity round.

Given the current landscape and investor expectations, we typically advise founders to not swim too hard against the tide, but also not mindlessly drink the overly “standard” Kool-Aid. Yes, templates like the Post-Money SAFE have gained significant market share, but what you don’t hear as much in the (simplified) data is that they are still being negotiated, particularly on the anti-dilution economics issue discussed above.

Many founders are very uncomfortable with promising their SAFE holders anti-dilution for years, given how equity rounds have been pushed further into companies’ growth. Six years after the Post-Money SAFE’s release I still have not heard a logical argument for why if a startup successfully closes $X million as preferred stock, all prior investors get diluted (what normally happens), but if it happens to be a SAFE round (same valuation, same amount raised), no investors get diluted. Why is the paperwork structure of the round relevant to whether investors get diluted?

Many smart founders modify the Post-Money SAFE (lightly) to address the investor-biased anti-dilution issue. Changing just a few words in the Post-Money SAFE can, for a company that achieves at least a $100 million exit, amount to millions of dollars in the pockets of common stockholders (founders, employees) instead of VCs or accelerators. Anyone who thinks at least trying to make this change isn’t worth it, out of some fear of “friction” – isn’t (IMO) defending their cap table enough. (If you want to see this redline - just reply to the newsletter)

Remember that this modification still promises investors the cap table percentage that the post-money valuation cap implies. If they put in $1 million at a $10 million post-money cap they are getting 10% today, effectively. What the “fix” does, however, is ensure that 10% shrinks pro-rata if you do a new SAFE round in 6-12 months with a higher valuation cap. Because that’s what would happen if you’d raised that $1 million as an equity round instead, or as a convertible note or pre-money capped SAFE. This idea of promising non-dilution to SAFE investors was completely novel, unnecessary, and introduced by YC, costing founders a lot of money. 

Of the founders I observe actually trying to fix the Post-Money SAFEs problems, a material number (but not all) have it accepted by their investors. They send a simple markup early in the process, a little discussion happens, and investors either OK it or they don’t. It ultimately comes down to leverage, which no lawyer can change for you.

For founders unable or unwilling to push for this change, other possibilities are:

A. At a minimum understand the anti-dilution issue, and factor it into your modeling of subsequent rounds. View future SAFE dilution as stacked on top of what was previously given to SAFE investors. The earlier SAFE holders are not themselves being diluted, which means you (the founders) are being diluted more. Your valuation caps in future SAFE rounds thus need to be higher to account for the more aggressive founder dilution.

B. We’ve also seen some founders, instead of tweaking the Post-Money SAFE, simply switch back to an old school pre-money formula. I personally find this a bit awkward in the context of investor expectations of 2024, but it certainly happens sometimes.

C. Convert your SAFEs as soon as possible. This is the advice I give to YC founders, and the advice I give to anyone who has raised a substantial amount of money on unnegotiated Post-Money SAFEs. Cut the anti-dilution off as soon as you can by raising a seed equity round, even a small one. 

Startup finance continues to evolve. Templates are useful as starting points of a negotiation. They’ve dramatically streamlined the earliest stages of funding, as the number of pre-seed and seed funds (and deals) has exploded. But be skeptical of anyone suggesting that those templates are never negotiable. They most certainly (often) are. The tiniest amount of negotiation can save you and your team millions of dollars. Don’t foolishly leave money on the table.

About Morgan
Morgan, besides running Tech Breakfast Club, is a Startup Lawyer at Optimal, an elite lean boutique startup law firm repping clients funded by a16z, Sequoia, Kleiner, Accel, and countless other VCs. He works with clients from formation to exit, in collaboration with Optimal’s partners.

Have a legal question? Reply to the newsletter. Happy to chat.