In 2018, YCombinator changed its Simple Agreement for Future Equity (SAFE) from a pre-money valuation cap to a post-money valuation cap, which can be significantly more dilutive to founders.
Learn more about valuation caps here.
When SAFEs and other convertibles (i.e., convertible notes) convert at the valuation cap, they convert into preferred stock at a price (Conversion Price) determined by:
The Conversion Price determines how many shares investors receive when they convert, which, in turn, determines how much the founders are diluted.
The difference between a pre-money and a post-money valuation cap is the number of shares included in the denominator of the Conversion Price equation.
For a pre-money valuation cap, the fully diluted capitalization excludes the shares the investors receive when they convert (Conversion Shares):
For a post-money valuation cap, the fully diluted capitalization includes the Conversion Shares:
Let’s consider two scenarios where a company raises $2M on SAFEs with an $8M valuation cap, the only difference being a pre-money valuation cap (Scenario 1) and a post-money valuation cap (Scenario 2).
Scenario 1 ($2M raised on an $8M pre-money valuation cap)
In Scenario 1, our Conversion Price is $1.33, being $8M (valuation cap) divided by 6M shares (the pre-money fully diluted capitalization):
Because the $2M investment converts at a Conversion Price of $1.33, the investors will receive 1,500,000 shares at conversion:
Scenario 2 ($8M post-money valuation cap)
In Scenario 2, our Conversion Price is $1.00, being $8M (valuation cap) divided by 8M shares (being the pre-money fully diluted capitalization (6M) plus the Conversion Shares (2M)):
Because the $2M investment converts at a Conversion Price of $1.00, the investors will receive 2M shares at conversion.
Unlike with the pre-money SAFE, these 2M shares were included in the fully diluted capitalization, which lowered the Conversion Price (from $1.33 to $1.00):
So, what happened?
Because the post-money valuation cap results in more shares included in the denominator of the Conversion Price equation, the investors convert at a lower Conversion Price, resulting in their investment buying more shares, further diluting the founders.
For founders, dilution gets worse when the company receives more money.
Just look at two scenarios where the company raises $4M on an $8M valuation cap.
Scenario 3 ($4M raised on an $8M pre-money valuation cap)
Scenario 4 ($4M raised on an $8M post-money valuation cap)
Raising an additional $2M on a post-money SAFE substantially diluted the founders and option pool.
Why?
Well, the Conversion Shares were not included in the fully diluted capitalization for the pre-money SAFE, so they did not lower the Conversion Price, which, in turn, did not significantly impact the number of shares the investors received.
Negotiation points
Founders often spend a ton of time and energy negotiating for a higher post-money valuation cap when they may be better off negotiating for a lower pre-money valuation cap.
For instance, let’s look at a scenario with $4M raised on a $10M post-money valuation cap.
Scenario 5 ($4M raised on a $10M post-money valuation cap)
In Scenario 5 (above), the founders secured a higher valuation cap but suffered more dilution than if they had negotiated a lower pre-money valuation cap, such as the $8M pre-money valuation cap in Scenario 3 (below).
Take Away
When investors reference a “valuation cap of $X,” ask if they mean pre-money or post-money; or, even better, suggest a pre-money cap.
If investors don’t budge on the amount of the valuation cap, see if you can find a compromise with a pre-money valuation cap.
Being proactive on early-stage investment terms will help founders tremendously over the long term.
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Disclaimer
While I am a lawyer who enjoys operating outside the traditional lawyer and law firm “box,” I am not your lawyer. Nothing in this post should be construed as legal advice, nor does it create an attorney-client relationship. The material published above is intended for informational, educational, and entertainment purposes only. Please seek the advice of counsel, and do not apply any of the generalized material above to your individual facts or circumstances without speaking to an attorney.
