As seed-stage investors, we at Ulu Ventures are lucky to cross paths with entrepreneurs who are tackling the next great set of challenges across the enterprise, consumer, healthcare, and sustainability spaces. At the seed stage, most of the founders we meet have mustered the courage to quit their regular jobs, convinced their loved ones of their drive and focus, and often raised some friends-and-family capital to get started. It’s an exciting time to be building something from scratch.
Technology businesses starting today are incredibly capital efficient compared to the first generation of internet companies. When I was the director of finance at an early-stage startup in the year 2000, we wrote a $550,000 check for back-end development and a $720,000 check for front-end design, all while we were still a zero-revenue eCommerce startup. Times have changed for sure—but it still costs money to get a company launched, so financing conversations remain critical.
Plenty has been written about SAFEs versus convertible notes regarding what’s founder-friendly versus investor-friendly, what’s debt and what’s not, etc. The important thing for entrepreneurs to understand is how these large convertible securities loom in capital structures; this is where SAFEs get unsafe and notes get gnarly! It’s like an iceberg … the convertibles and SAFEs below the water are deadly, even though the bit poking up above the waterline looks great.
Raising money in convertible securities is often quick: the documents are easy and there are fewer terms to negotiate. Once the money is raised, these notes sit on the balance sheet as debt in the case of convertible notes, and as a promissory “secret handshake” if we’re talking about SAFEs. It’s common for us to see companies that have raised several rounds of convertibles, often with improving terms to the company, such as higher caps or lower discounts. This is generally great, because that capital is being put to good use in hiring teams and building products. However, the debt keeps growing—and we find that many or even most founding teams only loosely understand its future impact.
In a world where everything seems “up and to the right,” entrepreneurs often expect that their first priced round will be above the cap of their most recent SAFE because progress has been made. Surely investors will reward founders with an increased valuation! The problem is often not the new money coming in at a new price, but the impact of the SAFEs and convertibles that have been lurking in the shadows.
Let’s assume founders raise a new round priced at $15 million pre-money and raise $4 million. This transaction resulted in a $19 million post-money valuation, so the new money bought 21% of the company (4M ÷ 19M). However, let’s say they were also converting $3M of SAFEs or notes that were raised in the past. To keep the math easy, let’s also assume that the founders aren’t converting at caps that are significantly lower than the $15M pre-money of the new round and that all of the notes are converting at $15M pre-money. They’ve now “raised” $7M ($4M raise + $3M converting) at $15M pre- (now $22 million post-money), selling 32% of the company (7M ÷ 22M). In reality, the financing could be even more dilutive because (a) the caps on the prior notes/SAFEs are actually lower than the pre-money or (b) the SAFE discounts often lead to conversion points south of $15 million. To pile things on, most investors are also going to negotiate a pre-money option pool refresh to increase the resources needed to hire great talent. That refresh is dilutive to common stockholders (and any existing shareholders). Suddenly, founders are diluted 40-50% in the new round.
So what happened? The breakdown is due to valuation. For many companies, the pace of valuation increase is not enough to offset the dilution from the size of the rounds being raised and the convertible securities being converted. When founders are lucky enough to experience exponential valuation increases because markets are flush with excess cash or because entrepreneurs outperform and earn those increases, then the math outlined above is less of a problem. However, in most normal markets, balancing capital raised (and converted) relative to valuation is a challenge for early-stage businesses.
There’s no silver bullet on how to perfectly deal with this, but here are a few things I’ve seen over the years that address the dynamics outlined above:
- Raise the Right Amount of Money. As Miriam Rivera and Clint Korver—my partners at Ulu Ventures—like to say, for any given round, raise enough money to get to a point in the future where founders can demonstrate a milestone achievement, a value inflection point, or something that says they’ve made real progress and are worthy of more capital at a substantially higher price point. We often meet with founders who say, “I’m raising $500k in my pre-seed.” Upon further digging, that number is totally arbitrary. No one said an entrepreneur had to raise $500k or $750k in a pre-seed. Maybe it’s $300k, or $800k—they should raise what they need to create some real value and put some points on the board. If founders raise from a position of strength, they will have a higher chance of achieving a better valuation in the future.
- Price Rounds Early. Founders should raise a SAFE to get going, but then move to get a priced round done quickly. Founders often tell me they like SAFEs and notes because doing so allows them to kick the can on valuation further down the road. This approach only plays out if future valuations are likely to be super strong. Even for the better-performing companies, especially in today’s market, I think that’s a low-probability strategy to play.
- Manage the Size of the SAFEs Relative to the Rounds. Entrepreneurs should consider raising SAFEs and pricing rounds at sizes that are manageable in their capitalization. In other words, raise a few million in a SAFE, then price a round of similar size. Better yet, price a round where the converting SAFE and/or convertibles are much smaller than the new money.
- Measure the Iceberg under the Water. If a founder wants to start layering SAFEs and notes over time, they need to do the math. They need to calculate how those convertibles are going to convert across a range of pre-money valuations in a future priced round given the associated price caps and discounts. The pre-money valuation in a new round is meant to reflect the value created by the performance of the business, not the idiosyncrasies of prior investment. I hedge a little here because sometimes we see founders who have been, or will be, overly diluted by prior securities issuances or by converting securities. In some cases, we have used a large option pool refresh to make sure founders are well-incented to stay with and grow the business by post-financing increases in their options, but that’s an extremely rare occurrence relative to the number of messed-up cap tables we see at seed stage.
- Think Strategically about Dilution. Most Series A (or later) investors want to see founders vesting in large portions of their business. This means founders need to be capital-efficient and smart about round sizes and valuation. Founders should strive to not end up at Series A with a cap table that needs restructuring. Most of the time, investors are wary of coming in to “play the heavy” with respect to prior shareholders, especially when there are so many other Series A companies that both created significant value and managed dilution effectively that provide more attractive investment opportunities.
Ulu partners with businesses at an early stage and part of that partnership is thinking through the math: the nuts and bolts of a startup’s business model, the unit economics of the product, the bottom-up of the TAM, and the cap table. All of these elements are important for setting up entrepreneurial teams for success—but ignoring any of these areas can put the company in jeopardy.