Is a SAFE Instrument Truly Safe? The Case for Priced Seed Rounds over SAFE Note

As a startup founder, understanding how different funding instruments affect your share ownership after you raise capital is crucial. Let’s consider two hypothetical founders, Founder 1 and Founder 2. Both founders raise a total of $7.9M by their Series A rounds, but Founder 1 ends up with 44.8% ownership while Founder 2 ends up with 50%.

Before Series A:

• Founder 1:  raises four rounds using SAFEs (Simple Agreement for Future Equity).
• Founder 2:  raises two rounds using SAFEs, followed by one priced round. 

But why, in this case, do similar fundraising amounts at the same valuation lead to different levels of founder ownership? To better understand what has made the difference here, let’s take a few steps back in time. 

Introduction to SAFE and its Origin

In late 2013, Y Combinator introduced the SAFE document, revolutionizing early-stage fundraising. The post-money SAFE, released in 2018, enabled the assumed ownership to be measured after (post) all the SAFE money is accounted for.  Since its release, the post-money SAFE has been used by almost all YC startups and countless non-YC startups as the main instrument for early-stage fundraising.  

A SAFE is a contractual promise that allows investors to convert their investment into preferred shares at a future equity round, without setting an immediate valuation. It simplifies the fundraising process by outlining the conditions for the capital to convert into equity, typically including a valuation cap.

African tech startups have embraced SAFEs due to their simplicity and speed. High-growth companies, such as Paystack and Flutterwave, have benefited from SAFEs, which have simplified their fundraising process, with minimal negotiation and legal complexities.

What is a Priced Equity round?

A priced round, also known as a preferred stock financing or priced equity round, is when a financial investment is exchanged for stock in a company based on a negotiated valuation of that company. 

The investor is granted a certain number of shares based on the valuation and the amount of funds acquired. Unlike SAFE and convertible notes, in a priced equity round, the proportion of the total allotted shares in the company is granted to the investor immediately rather than at a future round.

The key aspect that makes a round “priced” is that there is a price per share, allowing stock to be sold as a set number of shares. The investors provide the capital to the company at a predetermined valuation based on an equity stake.

The Dilutive Impact of SAFEs vs. Priced Rounds

Dilution refers to the reduction in the shareholders’ ownership stake as a result of issuing equity to investors. With the assumption that almost all startups fail, it's critical to have motivated founders to increase the chances of success. For investors, getting a larger piece of the equity pie is worth "zero" if the lack of motivation of the founding team leads to failure.

With the emergence of additional rounds such as seed extensions and pre-series A, startups often pile up multiple SAFEs at different times for capital influx. However, SAFE Notes only dilute the existing shareholders (i.e., founders, stock option holders) and not the SAFE noteholders, as they aren't shareholders yet. On the other hand, priced rounds dilute all shareholders, including investors, minimizing the impact on the founders.

In our hypothetical scenario above, Founder 1 raised four rounds using SAFEs, diluting only the existing shareholders, the founders. However, Founder 2 raised a priced round prior to Series A, and all SAFEs converted to shares by that round. Thus, the dilutive impact of the Series A round was less on the founders because it was shared by both the founders and existing investors.

The additional SAFE rounds raised by Founder 1 resulted in increased dilution because they only affected the existing shareholders (i.e., founders), while the equity round diluted both shareholders and investors.

Founder 2's approach demonstrates that opting for a priced round at the right time, rather than repeatedly using SAFEs, can help minimize dilution and enable founders to maintain a larger ownership stake. In this scenario, Founder 2 has an ownership stake of more than 500 basis points larger than that of Founder 1.

In conclusion, as startups navigate the evolving landscape of funding rounds, including emerging options like seed extensions and pre-Series A, it's crucial to be mindful of the implications of using multiple SAFEs with increasing valuation caps. This approach can inadvertently lead to a larger portion of the company being relinquished compared to if a priced round had been pursued earlier. Therefore, selecting the right funding instrument is not just a financial decision but a strategic one that can significantly impact your startup's trajectory and your stake in it.

As you craft your funding strategy, carefully consider the long-term effects on your dilution and ownership stake. While SAFEs can offer benefits for early-stage funding, a well-timed priced round, even at the seed stage, can help founders retain control of their companies and maximize their ownership as they grow and scale.

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