What is the difference between “pre-money” and “post-money” valuation cap SAFEs?

Takeaway: Post-money valuation cap SAFEs set a firm ceiling on the valuation the SAFE converts at irrespective of how much money the company raises via SAFEs or in a preferred stock financing. If the company sells too many SAFEs, the existing stockholders (e.g., the founders) bear the dilution. Pre-money SAFEs do not have this issue and, in my opinion, are preferable from the founders’ perspective.

When startups raise money through a Simple Agreement for Future Equity (SAFE), there are two different types of valuation caps: pre-money and post-money. The difference between the two types of valuation caps is important and can impact both the amount of dilution that the founders incur and the amount of equity that investors receive in exchange for their investment. Post-money SAFEs have the potential to dilute founders much more than pre-money SAFEs.

Math Behind SAFEs

When SAFEs convert into equity, they either convert at a discount or at a valuation cap. The discount is simple - it is usually 20% off the price the new cash investors pay in the next financing. The valuation cap is where the big difference is. With the valuation cap, the conversion price is as follows:

Conversion Price = Valuation Cap / Company Capitalization

The lower the conversion price, the more shares the investor receives. This means that the higher the valuation cap, the fewer shares the investor receives and the higher the company capitalization, the more shares the investor receives. The more shares are issued to the investor, the more dilution incurred by the founders.

Pre-money SAFEs and post-money SAFEs calculate “company capitalization” differently. Pre-money SAFEs exclude all shares issuable upon conversion of convertible notes and SAFEs. Post-money SAFEs include all of those shares issuable upon conversion of convertible notes and SAFEs.

When Y Combinator (YC) came out with the SAFE in 2013, its first SAFE was a pre-money SAFE. YC has since switched its form to a post-money SAFE, arguing that the post-money SAFE allows founders and investors to always calculate the amount of the company they are selling. That may be true but, in my experience, it is only that simple if a company only issues one set of SAFEs at a single valuation cap. If a company issues SAFEs at different valuation caps, which happens frequently as companies grow, it becomes very difficult to keep track of how many shares are issuable upon conversion of the SAFEs. It is actually possible with post-money SAFEs for the founders to essentially be completely wiped out - I’ve never seen that happen but the point is that it can be difficult to keep track of how much of the company you are selling and the founders bear a lot more dilution with post-money SAFEs.

Pre-Money SAFE Example

In this example, assume there is a company where the founders own 8 million shares and employees own 2 million shares (so there are 10 million shares total outstanding), which is a common early capitalization for startups. If the company sells $5 million in pre-money SAFEs, each with a $10 million valuation cap, the conversion price on a pre-money SAFE will be $1.00 ($10 million valuation cap divided by 10 million shares outstanding). The conversion price on these pre-money SAFEs would stay the same whether the company sold $1 million of SAFEs or $20 million of SAFEs. In this situation, the SAFE investors would receive 5 million shares of stock ($5 million investment divided by $1.00). After the financing, the founders would own 53.3% of the company (8 million shares held by the founders divided by 15 million shares total outstanding).

Post-Money SAFE Example

Assume the same facts - there is a company where the founders own 8 million shares and employees own 2 million shares (so there are 10 million shares total outstanding). If the company sells $5 million in post-money SAFEs, each with a $10 million valuation cap, the conversion price on a post-money SAFE will be $0.50 ($10 million valuation cap divided by the 10 million shares outstanding plus the 10 million shares issued upon conversion of the SAFE). In this situation, the SAFE investors would receive 10 million shares of stock ($5 million investment divided by $0.50). After the financing, the founders would own 40% of the company (8 million shares held by the founders divided by 20 million shares total outstanding). The conversion price math gets more complicated (and less favorable to the founders) as you add more post-money SAFEs with different valuation caps.

Conclusion

The difference between pre-money and post-money valuation caps can have a significant impact on the amount of dilution incurred by the founders and the amount of equity that investors receive in exchange for their investment. Investors will typically prefer post-money SAFEs so, to the extent possible, it is important to work with your lawyer to determine which is right for a given situation and negotiate the type of SAFE up front.