The Debt Sandwich Part II - When is a SAFE not so safe?

Ari Newman
Feb 23, 2022

When is a SAFE not so safe? Or, when does ‘Uncapped’ actually mean the opposite?

There has been no shortage of hot takes on YC’s new ‘Uncapped SAFE’ deal and what it means for the early-stage founder and venture community. It's causing headaches for pre-seed VCs, downmarket accelerators and Angels. Some founders will salivate at the idea of a bigger check with super favorable terms from YC. On the surface this may all look great for founders and for YC, but in reality there are some major problems that, as usual, will only show up later. 

Note: Before we go any further, please note this post is really about how to avoid pitfalls and risks associated with raising successive convertible debt rounds, not about YC’s deal specifically, but we thank them for giving us a reason to discuss it. 

The YC uncapped note is a bit of a smokescreen, which is to say that it seems like a great deal largely thanks to the MFN (Most Favored Nation) clause.  In essence, it’s a ‘lowest-possible cap’ note that incentivises founders to take the highest valuation deal they can, or to delay raising an equity round until they are “crushing it”. We hear this constantly - the idea that not pricing a company until it's a rocketship is the way to go, that it helps minimize dilution, etc. Up until now (Q1 2022), we’ve been in a bull market with tons of dry powder, many new/first time VCs and lots of capital to be deployed. In this kind of environment, it’s easier for companies to get away with delaying raising a priced round for longer. New investors have motivation and eagerness to deploy capital and experienced ones sitting on bigger pools of capital have leverage and understand the arbitrage and power law realities of early stage investing. One group is willing to pay up and the other is less price sensitive…and so here we are. 

The renewed discussion around all of this has turned into a great catalyst to revisit our very popular Debt Sandwich article and to share some of our deeper thinking on two topics: The preference most founders have of using SAFEs (or any convertible debt instrument) as the sole financing vehicle for their startup until a “favorable priced round makes sense;” and, diving deeper into what we call the ‘Debt Sandwich’ strategy when it comes to long term fundraising. 

There is broad acceptance that SAFEs (or convertible notes) work well for early funding and for accelerators like YC or Techstars for myriad reasons. A few of them are:

  • Founders love them because they are quick, easy and don’t require a formal closing and are perceived to have lower legal costs. 
  • Angels and early investors love the caps that ‘protect’ them for the substantial early risk taken. 
  • Accelerators use them because they are a practical and efficient way to fund hundreds of companies quickly. 

So - what’s the problem? What are you getting at? 

“Founders are often given valid but over-simplified advice when it comes to debt financing. Some of the “mostly true” points include; debt rounds cost less from a legal standpoint, that you can negotiate a higher conversion cap (implicit next round valuation target) than a priced equity round, and you can raise money progressively (one investor at a time). [However]...debt rounds become problematic because each round of debt comes with its own discount, its own conversion cap, and other rights/terms.”

From “Why Your Startup Should Eat a Debt Sandwich” 

One real danger is the ease with which they can be used without understanding the real and serious impact they have on dilution when they convert. Another is the complexity they can bring to a future priced equity round closing. A third is the uncomfortable dynamics that put founders in a “short-squeeze” between early investors who took tons of risk and the new money that is focused on ownership. There are others, of course…

The features of a SAFE exist to protect and incentivize angels, early stage investors, or bridge investors - the people that take the early, or outsized, risk. Because these risks are significant, the features exist because those kinds of investors should be fairly rewarded when a startup they backed from the beginning finds huge success. Or, a bridge investor should be rewarded for stepping in to help a company extend its runway to be in a stronger position to raise their next equity round or prepare for a sale.  Without strong reward for the risk, these kinds of investors would be much less willing to invest. 

Here’s the big thing: SAFEs (and certainly Conv. Notes prior) were conceived as bridge instruments - something to help a company get off the ground or bring in needed capital between rounds -  but always with an eye towards an impending equity round where they could convert into equity. They were never meant to be a primary financing instrument to drive operations for 2-4 years. But unfortunately, this has become closer to the norm recently. It all seems fine until it's time for the priced round and all of the rights, conversions, and dilution protections hit at once. 

Recently, we’ve been operating in a strong market where a Pre-Seed round can be $2-3M and the Seed round looks a lot like a strong Series A round used to, i.e. 5-10M range. We are seeing companies raise on SAFEs until these bigger rounds happen, and by then the company could have 40-80 (100?!?) SAFE holders, who all need to convert into the priced round, many at different economic terms (caps, discounts, etc). Frequently, SAFEs and Notes convert immediately PRIOR to equity financing. This means that the new equity investors don’t suffer any dilution the minute they invest but the converted shares are part of the round. We’ll come back to this one. 

A common practice is to continually ratchet up the conversion cap on the SAFE whenever possible (less dilution!). Picking on YC’s new deal again as illustration - this mindset may only get worse in the industry as the incentive to keep raising on SAFEs at high caps will persist. With the YC MFN clause, the incentive is to find the investor that will give you the highest valuation so the YC capital is the least dilutive as possible. This will undoubtedly influence angel and seed investors across the spectrum as these deals hit the market. 

This sets a very high bar for the priced round, because even though we don’t want to admit it, when you’ve raised $4M on SAFEs and the latest one was at a 30M cap, you are signaling to your investors and yourself that this is around where the equity financing should land. Founders begin to see that as both the valuation and your term sheet target, even though the cap is not the price of the company, it becomes the “shadow price”. This is all good, unless you can’t justify that valuation based on traction, or until the market cools off or you need more cash, and your options become 1) raise at a lower cap, and offer that to the other SAFE holders (if they have MFN/anti-dilution rights), or 2) do a priced round at a lower cap and convert, which will look and feel like both a down-round and can be even more dilutive. 

Upon conversion, each issuance of SAFEs or Conv. Notes that have different terms may need to be converted into a separate class of Preferred stock. Each class may have its own share price, and its own conversion math. If the terms or rights (side letters?) are different, this adds more complexity. Complexity = time, risk and expense of the closing. All sorts of questions and issues can come up, especially if the historical paper trail is not perfect. If you’ve been told “just use a SAFE, its quick and easy and you don’t need a lawyer”  - just remember you’ll end up paying the lawyers later on to untangle and organize all of the convertible and the pro-forma cap table. So you can pay a little now (a pre-seed priced round closing should not cost more than $10k) or pay a bunch later while the deal closing drags on. 

Expanding on some of these complexity warnings, it is worth calling out the obvious. Investors can be fantastic resources and helpers when they are in your corner. They can also be fickle and easy to spook when trying to raise. We’ve seen situations where investors look at cap tables and walk away for annoying vague reasons like  “too messy to deal with” or specific ones such as “the founders won’t own enough to be incentivized to work hard for the next 10 years and I’ll take too much dilution later to fix it”. We’ve also witnessed the short-squeeze where the founders who took in millions at low caps on SAFEs or Notes that are going to convert with 2-4x buying power have to go back to these early backers and try to renegotiate the terms of the SAFEs because the new investors need to own X and want the founders to own Y. The only other variable they see is Z = conversion price of SAFEs/Notes. These can be very ugly situations. Wish this was fiction, but we’ve seen it go down.  

There is another side effect of successive convertible rounds, which is a delay in the company’s fiscal and operational maturity. For many companies, not raising a priced round seems like a way to avoid having a Board. It may mean avoiding a 409a valuation or filing 83b elections. It may mean weaker financial reporting and not bothering to onboard with cap table management. All of these things may seem like wins for a busy startup because they are extra work or overhead, but when you kick the can, it  just gets bigger and that much harder to move later. Companies with millions of investor dollars on the books were meant to have operational support and to be following some simple best practices. Today we see companies with 5M invested and 30M valuations that operate like pre-seed companies. No lead investor, no board support, no one accountable -  just a Dropbox folder full of signed SAFEs. Again, this is all good when everything is up and to the right and the next round just works out but for many companies this is not reality and good operational hygiene starts to really matter. Other risks vectors that show up when you delay all of this via the successive SAFE approach, include making the company hard or impossible to underwrite for debt financing or a bridge, it can make what should be a quick M&A process drag on or fail, or make the eventual priced round financing take months to close and cost a lot in terms of distraction, stress and money. The worst outcomes would be unknowing violations of Securities laws or failures to file documents, putting the company at risk for fines or investor action, and mistakes with 409a, 83b or QSBS that could cost the founders, company or investors millions later on. 

Note: This is one reason why we advocate for onboarding with a digital equity management solution like Carta early on. Having your cap table properly managed out of the gate will save a lot of time, money and headaches upon conversion or future financings later. Massive is an investor in Carta, for full disclosure, and that’s exactly why. 

While we have tons to say about getting too far over your skis on valuations, we’re going to stay focused here on the realities behind SAFE conversions by sharing some of the downsides and serious risks that only start to manifest in a contracting/corrective market. Since we are now in this territory, we wanted to share some details on what to be careful around and how to mitigate the risks. 

To illustrate how these financings play out, let's work through two examples. 

Example #1 

You’re the founder of Company A, which has been around for two years and raised $2M in Pre-Seed on a $6M post-money SAFE. After about 8 months of building, you get some inbound interest and decide to raise another $1.2M on an 8M post-money SAFE. Now two years in, and burning $175k month, you realize you’ll have to raise in Q4 but are getting tight on cash, so you go back to the investors and offer them another $1M SAFE at a $15M cap.

Total Raised: $4.2M

$2M @ 6M cap
$1.2M @ 8M cap
$1M @ 15M cap

You decide Company A is finally ready for an equity round. You find a good lead investor for a Seed round and get a term sheet for $6M on $20M pre. Awesome, right? You are generally happy with this, it looks like it's only 23% dilution ($6 in new money on $26 post). But then you start to understand the following: 

  1. Need to add 10% in dilution for the new option pool. The one set up at formation is now exhausted, or you never set it up because it was always “when we do the priced round”. 
  2. All the different SAFE conversions, because of their caps and discounts, actually convert to $9.57M in the priced round. So in total, presuming the conversion happens prior to the financing as does the option pool, so as to not immediately dilute the new investors, the total round is actually $15.57M/$26M for 60% dilution. Add the 10% option pool and this round is 70% dilutive to the existing cap table. 
  3. Don’t forget about the pro-rata rights some or all SAFE holders in the Seed round now have either in this round or in the Series A - depending on if they were offered via side letter or in the SAFE itself, etc. These can push the dilution higher or even make the next round harder to close when 80 small investors all have a pro-rata right. 

See the table below for a summary of how this works out. 

The paper value of your shares as a founder following this priced round is $7,047,000.

Example #2

Now let’s look at the same sequence but from a ‘Debt Sandwich' point of view, with a priced round in between the two SAFEs. 

If you have stayed with us this far (thank you!) but not previously read the original Debt Sandwich post, we’d suggest you take a short detour so you understand this strategy. TL;DR - raise priced rounds in between debt / convertible rounds every time. Sandwich the debt with equity! 

Total Raised $4.2M 

$1M @ 6M Cap SAFE [SAFE 1]
$1.2M @ 10M post (Series Seed-1 priced round)
$2M at @ 20M post [SAFE 2]

  1. SAFE 1 converted at 1.4x into the Series Seed-1. $1.4M + $1.2M in new money = $2.6M on 10 post = 26% dilution. 
  2. At this time the company topped up the option pool by 5% since it wasn’t fully exhausted. Add 5%. Total dilution was 31% and the post-money valuation is $10M. 
  3. Now that the company has been priced and shares have been allocated to investors, they are in a stronger position to raise the last $2M SAFE at $20M post vs $15M. This will make this additional 2M less expensive when the next priced round happens. 
  4. The new $6M round at the $26M post ends up at 23% dilution and the $2M converts at $2M. Total round is $8M resulting in 31% dilution to the entire existing cap table (including last round’s investors). The company doesn’t need another option pool refresh here in the Series Seed-2 as it was handled in the first priced round. Total dilution for the original members of the cap table across three financing cycles = 51%. 
  5. Bonus: There is room to increase the option pool, and there is room to plus up the founders or key employees with additional grants. The SAFE 1 holders with pro-rata rights would be either exercising or losing their rights in the Series Seed-2.

Following the second priced round, the paper value of your shares as a founder is $10,987,826. All else equal, you’ve gained almost four million dollars in paper value from this shift in how you handle the financings. You own more of the company which is good for you AND for the next round lead investor that wants you incentivized. You’ve put the company in a better position if you need to raise more capital, likely have implemented at least a few corporate hygiene best practices and are reporting to your investors on a regular basis. You know what the company is truly worth as do your employees and investors.

As an aside, if you want to play around with numbers like these without building your own calculations, Carta offers an excellent free tool where you can enter in all your SAFE details and see what happens when they convert.

We want to be clear that Massive is NOT anti-SAFE or Conv. Note. nor are we saying “don’t use them”.  We actively invest in SAFEs and Notes and do not discourage founders from using them when appropriate. We are sharing our perspective on the realities of abusing SAFEs and shining light on a topic we feel is often ignored or overlooked.  Our advice is to seek out an investor who will partner with you to lead or participate in a priced round in between debt/convertible rounds. 

In Summary: 

Pitfall #1 - Beware of stacked SAFEs - Remember that the buying power can turn into substantial dilution if not converted for years.  You will end up owning more of your company with the debt sandwich strategy. You will benefit from the cleanup events and you’ll have more doors to remain open for the company from a strategic standpoint.

Pitfall #2 - Easy Money is not Smart Money - Remember that investors (even awesome ones!) are incentivized to maximize ownership and to manage risk. Low conversion caps at pre-seed and seed are 100% ok as investor incentives to take a ton of risk, but were not meant to be the primary financing vehicle for a long time! You don’t have to run the company for years growing its enterprise value and turning these SAFEs into “SuperSAFEs” that convert with huge buying power. Smart money takes a longer view. It looks at today, at the opportunity for great return -  but also looks ahead to ensure the company can be financed in the future and the founders are going to own enough. 

Pitfall #3 - Lemmings follow lemmings off the cliff - We are not saying all investors are lemmings, but how many times have you heard “do you have a lead?” or “I want the same terms as XYX investor!”  - investors just want a fair and consistent deal, and they take signals from each other’s conviction. Also - let's be honest here, investors can be quite lazy and just want to be “in”. When everyone assumes the other person is leaning in and really doing their diligence, you can end up with a lot of capital at your feet and very little guidance on how to manage it. 

A bridge too far?

Remember, SAFEs and Notes, while convenient compared to an equity round, are meant to be a ‘bridge to something.’ They are not meant to be a process for ongoing fundraising. So, always think of them as the filling in a funding sandwich. If you need to raise capital to get to a specific place, go ahead and draft up that SAFE. But make sure your mindset is to get them converted as quickly as possible into an equity round or these SAFEs won’t look all that safe anymore!

Understanding how financing affects your business is one of the critical jobs of the CEO. It’s worth understanding how to do it right over the long term.

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