Feb 18, 2022
SAFE & Dilution: Is Deferment Detrimental?
The Simple Agreement for Future Equity (SAFE) instrument has become a popular tool for seed funding early-stage financings in the United States and Canada. Venture Capital (VC) firms find SAFE more effective than convertible bonds for startup seed funding. Valuation and dilution are the critical elements in SAFE that determine a new financial structure for the startups and provide investors for startups an edge.
Pre and Post Money Valuation
Financially, about seed capital funding, dilution is not a big deal and does not indicate that the company's valuation is declining if, for example, a startup continues to grow. However, sometimes, founders prefer to defer the dilution while raising funds during Series A Round. Amongst venture capitalists and other startup investors, it's common to adopt two types of valuations- pre-money and post-money. A pre-money valuation is the value of a firm before the infusion of seed money in a funding round. The post-money valuation is the firm's value after the round has closed, and it's commonly computed by multiplying the pre-money valuation by the amount of money raised in the round.
Is dilution Detrimental?
Notwithstanding the growth and future prospects, founders of startups often prefer dilution at a later stage. And it happened several times even though startups were aware of the impact at the time of the finalizing of SAFE. When VC firms issue SAFE, and big fall out is that the founder's equity has to be impacted. For example, seed funding in Canada witnesses such a dilemma on dilution, and angel investors in Ontario make it clear right from the very beginning that the new financing structure or price will have its implications once they issue the SAFE.
Dilution and Control
Dilution matters a lot in terms of control and the company's voting structure. Because a shareholder's voting power is usually connected to the number and type of shares they control, founders and other investors may find themselves outnumbered during important votes as their percentage ownership of the firm gets diluted. Key stakeholders add anti-dilution terms in contracts to protect their control over a corporation.
Maximize Valuation, Minimize Dilution
When raising seed capital, some dilution is unavoidable, but founders can use tactics to minimize the impact on their and their investors' ownership targets. Valuation determines dilution down the line. The universal goal for any founder is to maximize valuation while minimizing dilution. Current versus future valuation, equity ownership pools, advisory shares and vesting schedules are the key elements. They have an impact on the level of dilution that startup investors can experience over time. Moreover, understanding the investor mindset, comparable company analysis for basic valuation, accurate assessment of capital needs, close eye on market opportunity, scaling, and realistic expectations are critical for companies starting out and have considerable investor interest. They should remember that the numbers will start to matter more -particularly in Series B and C rounds. Hence, it is critical for startups to ensure that goals are achievable and aligned with the valuation and dilution.
It’s an agreement that allows employees to share ownership in the company.
SAFE (Simple Agreement for Future Equity) notes are not debt, they are convertible equity, and there is no loan or maturity date.
Like top convertible equity notes, SAFE notes grant investors the right to receive a certain number of shares in a future priced funding round.
If a company decides never to raise funds in future, the SAFE continues in perpetuity without ever altering.