I wanted to continue on my last post considering the simple agreement for future equity (“safe”) by reviewing a couple examples of how a safe works.
As mentioned in the last post (Part 9 – Raising Funds through a Safe — follow to understand the concepts), there are a few combinations safes using levers such as discounts and valuation caps (or cases with neither which likely includes an MFN provision). Let’s walk through a few examples:

Example 1: No Discount, Valuation Cap

Post-Money Valuation
Investor Invests in Safe
$100,000
Discount Rate
None
Valuation Cap
$5,000,000
Post-Money Valuation
New Investment through Series A Equity Financing
$1,000,000
Pre-money Valuation
$10,000,000
Fully-Diluted Outstanding Capital Shares
11,000,000
Here, the company will issue sell shares at $0.909 per share ($10,000,000 ÷ 11,000,000 shares). Thereby, the company issues 1,100,110 shares ($1,000,000 ÷ $0.909).
However, the safe investor from earlier will be issued shares at $0.4545 per share ($5,000,000 ÷ 11,000,000 shares). The per-share price is based on the $5,000,000 cap as it is lower than the $10,000,000 valuation from the Series A fundraise. The safe investor would then be issued 220,022 shares ($100,000 ÷ $0.4545).
Note: this assumes the company does not pay back any amount of the initial $100,000 safe investment.

Standard Preferred Stock
Safe Preferred Stock
Price Per Share
$0.909
$0.4545
Investment Amount
$1,000,000
$100,000
Series A Preferred Stock Issued
1,100,110
220,022

Example 2: No Discount, Valuation Cap

Post-Money Valuation
Investor Invests in Safe
$100,000
Discount Rate
None
Valuation Cap
$4,000,000
Post-Money Valuation
New Investment through Series A Equity Financing
$600,000
Pre-money Valuation
$3,000,000
Fully-Diluted Outstanding Capital Shares
12,500,000
Here, the company will issue sell shares at $0.24 per share ($3,000,000 ÷ 12,500,000 shares). Thereby, the company issues 2,500,000 shares ($600,000 ÷ $0.24).
However, the safe investor from earlier will be issued shares at $0.24 per share ($3,000,000 ÷ 12,500,000 shares). The per-share price is based on the $3,000,000 valuation as it is lower than the $4,000,000 cap. The safe investor would then be issued 416,666 shares ($100,000 ÷ $0.24).
Note: this assumes the company does not pay back any amount of the initial $100,000 safe investment.

Standard Preferred Stock
Safe Preferred Stock
Price Per Share
$0.24
$0.24
Investment Amount
$600,000
$100,000
Series A Preferred Stock Issued
2,500,000
416,666

Example 3: Discount, No Valuation Cap

Post-Money Valuation
Investor Invests in Safe
$20,000
Discount Rate
80%
Valuation Cap
None
Post-Money Valuation
New Investment through Series A Equity Financing
$400,000
Pre-money Valuation
$2,000,000
Fully-Diluted Outstanding Capital Shares
10,500,000
Here, the company will issue sell shares at $0.19 per share ($2,000,000 ÷ 10,500,000 shares). Thereby, the company issues 2,105,263 shares ($400,000 ÷ $0.19).
However, the safe investor from earlier will be issued shares at $0.152 per share ($5,000,000 ÷ 11,000,000 shares = $0.19 per share * 80% discount). Notice that the price-per-share must be discounted to arrive at a discounted price-per-share. The safe investor would then be issued 131,578 shares ($20,000 ÷ $0.152).
Note: this assumes the company does not pay back any amount of the initial $20,000 safe investment.

Standard Preferred Stock
Safe Preferred Stock
Price Per Share
$0.19
$0.152
Investment Amount
$400,000
$20,000
Series A Preferred Stock Issued
2,105,263
131,578

Example 4: Discount, Valuation Cap

Post-Money Valuation
Investor Invests in Safe
$100,000
Discount Rate
85%
Valuation Cap
$8,000,000
Post-Money Valuation
New Investment through Series A Equity Financing
$1,000,000
Pre-money Valuation
$10,000,000
Fully-Diluted Outstanding Capital Shares
11,000,000
Here, the company will issue sell shares at $0.909 per share ($10,000,000 ÷ 11,000,000 shares). Thereby, the company issues 1,100,110 shares ($1,000,000 ÷ $0.909).
However, the safe investor from earlier will be issued shares at $0.72727 per share calculated by the minimum of:

  • Valuation Cap: $8,000,000 valuation cap ÷ 11,000,000 shares = $0.72727 per share.
  • Discount: $10,000,000 full valuation ÷ 11,000,000 shares = $0.909 per share × 85% discount = $0.77265
Thus, the minimum price-per-share is $0.72727. The safe investor would be issued 137,500 shares ($100,000 ÷ $0.72727).

Note: this assumes the company does not pay back any amount of the initial $100,000 safe investment.

Standard Preferred Stock
Safe Preferred Stock
Price Per Share
$0.909
$0.72727
Investment Amount
$1,000,000
$100,000
Series A Preferred Stock Issued
1,100,110
137,500

And…

You can find more examples on the Safe primer by the Y Combinator team here.
What questions do you have about safes? How do you view safes to be advantageous for both entrepreneur and investor?
A friend looking to raise money recently told me a new form of raising money I hadn’t heard of before referred to as a Safe (simple agreement for future equity). A safe is a mechanism Paul Graham and his YC partner and lawyer Carolynn Levy created as an alternative to convertible notes – refer Finance of Startups: For Dummies (Part 4) for a short description of convertible notes.

Safes are meant to remove the clutter and complications of convertible notes in that they are not debts themselves. Instead, they are agreements for rights to the purchase of future stock – goal is to convert safeholders into stockholders.
  • Convertible notes can be highly regulated via their maturity dates, interest rates, etc. Safes, on the other hand, have no maturity date and as they are not debt, are not beholden to regulations regarding interest rates.
  • Safes remove the complexity of having to extend maturity dates as there are none (vs. convertible notes).Safes are converted to equity at specific events such as an equity financing round, liquidity event, or dissolution of the company (insolvency).
  • Like convertible notes, there are variations to the safes – those with a discount, valuation cap, or some combination of those two (with/ without) or none at all – instead, with an MFN (“Most Favored Nation”) provision.
  • Most Favored Nation provision (MFN) are used to amend a safe’s terms with a safe raised at a later date. This is common for safes with no discount or cap set. Note: safe can only be amended once, not multiple times.
Safes have been a big hit for YC-backed companies, and have been finding traction here in ATL for early stage startups looking to raise funds quickly without the battle over valuation. For more details on safes, check out this primer.

What are your questions about safes? If you were a startup or investor, what would your apprehensions about safes be? Versus convertible notes?
I’ve somehow managed to keep this going for four months (including today) researching finance concepts, and blogging about them. Wow, it’s been a great exercise learning and sharing.
I admit my recent blog posts haven’t gotten me THAT excited where I’m openly sharing, but when I started researching and writing this post, I felt that excitement again.
So, anyways… moving on for today’s post – PART 4! The following topics will be covered:
  • Convertible Note
  • Discount (as part of Convertible Note)
  • Cap (as part of Convertible Note)
  • Dividend
  • Pro-Rata Rights

Convertible Note.

A convertible note is kinda, sorta, like-a hybrid of debt and equity financing. Here, the company and the investor delays setting a valuation for the company till a time when the company may raise another round with a valuation. Convertibles are a popular vehicle for early stage startups as it’s hard to discern the value of an extremely young company with little to no earnings.
So instead, the capital at the beginning is treated like a loan upfront. When the company raises another (or official) round, then the outstanding convertible note is converted to equity as a ratio of the valuation. However, to sweeten the deal for the inherent risk of investing early on, there are a couple levers that impact the conversion of the convertible:
  •  Discount – a percentage reduction the convertible note holders can convert to the principal loan amount relative to the purchase price of the next round. The discounts typically range from 0-35% with 20% being the most common. So if Series B round investors are paying $10 per share, the original investors who had a 20% discount on a principal amount of $100,000 can convert this loan amount at a per-share-price of $8 ($10 less 20%)… they’d get 12,500 shares at $8 each but valued at $10 per share.
Seed Round: You invest in a convertible note of…
Principal of $100,000 with a discount of 20% (convertible to Preferred Stock)
Series A: Awesome Venture Capital Firm invests…
$10 per share at a valuation of $10M (pre-money)
Your conversion price-per-share
$10 * (1 – (20%)) = $8 per share
Shares of stock
$100,000 / $8 = 12,500 shares of Preferred Stock
Book Value of stock (unrealized)
12,500 * $10 per share from round = $125,000 (25% unrealized return)
Series A investors would’ve gotten…
10,000 shares for $100,000 investment due to $10-per-share price
  • Cap – a maximum limit of the valuation that can be converted into equity at a later priced round. The investors will typically be priced at the lower of the cap or the valuation of the round. How this works…

Seed Round: You invest in a convertible note of…
Principal of $100,000 with a cap of $5M (convertible to Preferred Stock)
Series A: Awesome Venture Capital Firm invests…
$10 per share at a valuation of $10M (pre-money)
Your conversion price-per-share
$10 * ($5M / $10M) = $5 per share
Shares of stock
$100,000 / $5 = 20,000 shares of Preferred Stock
Book Value of stock (unrealized)
20,000 * $10 per share from round = $200,000 (100% unrealized return)
Series A investors would’ve gotten…
10,000 shares for $100,000 investment due to $10-per-share price

Dividend.

Dividends are disbursements of profits from a company to its shareholders. Dividends are post-tax, and typically abide by a dividends schedule. Though, companies can issues dividends at any time as “special dividends”.
On the opposite end of dividends, companies can also choose to reinvest its net profit into the business as retained earnings rather than issue dividends.
Dividends are more commonly issued as cash to its shareholders. Each dividend is fixed per share, but the total amount will vary depending on the percentage of the shareholder’s shareholding (ownership).

Pro-Rata Rights.

In PART 1, I talked about dilution – the outcome where ownership percentage may decrease when a company raises a round of capital at a higher valuation. Pro-rata rights enables investors from earlier investing rounds to maintain their shareholding percentage and avoid dilution by investing additional capital.
So if an investor invests $500,000 in Amazing Hair Gel Company with a post-money valuation of $2M, the investor has a 25% equity stake in the company ($500,000 / $2,000,000). If the company raises additional capital in a Series B with a post-money valuation of $40M, the investor has pro-rata rights to invest an additional $9.5M to maintain a 25% stake in the company (25% of $40M = $10M with an initial investment of $500,000 already).

Need Your Help Moving Forward!

All of this research has been making me so much more adept and savvy when reading posts about investments and valuations, and also much more knowledgeable talking to others about them. This has been a great exercise, but I think I can do better, but I need your help.
I’ve heard positive feedback so far, and I’m always looking for ways to explain things better. This stuff makes sense in my head as I’m writing it, but it’s largely been one-way communication. That is, I write and “teach” without the student-interaction that makes good teachers GREAT teacher. That is, in 1-to-1 teaching, the teacher (or presenter) and student (or audience) interact with thought-provoking questions. Heck, I oftentimes learn more through these interactions.
Short story – interactions help me learn and explain things even better. So if you have feedback, feel free to shoot me a message on Twitter (@TheDLu) or email so I can explain things better.
Till next month… Cheers!