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Starting a new business can be exciting but overwhelming when it comes to funding. The right decisions about how to fund a particular startup are crucial, as they determine whether a business succeeds.
Venture capitalist Dale W. Wood, founder and chairman of Dale Ventures Group of Companies, is an experienced investor who understands how to obtain the capital startups need to grow. Here, Wood shares his expertise on an important decision: choosing between Post-money SAFEs and Pre-money SAFEs.
These two ways of securing funding can be challenging to understand, but they can be essential for the future of startups. This guide will help entrepreneurs understand both options better and make the right choice for their business.
Understanding startup investment vehicles
When it comes to funding a startup, there’s no shortage of options, each with its own set of rules and implications. To make informed decisions, it’s essential to have a clear understanding of each. Let’s start by defining various startup investment options, including common stock, preferred stock, convertible notes and SAFEs.
Common stock: Common stock represents ownership in a company and often comes with voting rights. It’s a traditional way to raise capital by selling company shares to investors, but it can dilute the founder’s ownership and control.
Preferred stock: Preferred stock is another form of equity ownership, but it comes with preferences, such as priority in receiving dividends and assets in case of a company’s liquidation. It’s a popular choice for investors looking for more protection.
Convertible notes: Convertible notes are a form of debt that can be converted into equity when a specific trigger event occurs, like a future funding round. Early-stage startups often use them as a bridge between seed funding and a larger funding round.
Simple Agreement for Future Equity (SAFE): SAFEs are a relatively new form of investment, offering flexibility and simplicity. Instead of receiving shares immediately, investors get the right to convert their investment into equity in the future, usually at the next funding round. SAFEs have gained popularity for their streamlined approach to funding.
“The choice of investment vehicle isn’t a one-size-fits-all decision,” Wood said. “It should be tailored to your startup’s specific stage and needs.”
For instance, companies in the early stages of development that need quick funding to grow may choose convertible notes or SAFEs because they allow a business to secure funding without the immediate pressure of setting a valuation.
On the other hand, if a startup has reached a more mature stage and is looking for long-term investors, preferred stock may offer more stability and a structured approach.
“The significance of choosing the right investment vehicle also extends to the implications it has on ownership, control and future funding rounds,” Wood said. “Making the right choice can set your startup on a path to success, while the wrong one may lead to unnecessary complications.”
Pre-money SAFEs vs. Post-money SAFEs
In startup financing, there are two primary categories of SAFEs: pre-money and post-money SAFEs. The critical difference between the two lies in the timing of valuation.
Pre-money SAFEs determine the startup’s value before a new investment is added, whereas Post-money SAFEs calculate the value after a new investment has been injected into the company.
Historical context
The choice between Pre-money SAFEs and Post-money SAFEs stems from a historical evolution in startup funding.
Pre-money SAFEs were the initially popular option, especially during the early days of the SAFEs concept. Investors favored them for their advantage of potentially offering a higher percentage of ownership for their investment since the valuation was set before their money was added to the startup’s balance sheet.
However, as the startup ecosystem evolved, pre-money SAFEs began to exhibit certain shortcomings, leading to the emergence of post-money SAFEs.
Post-money SAFEs have gained prominence due to their simplicity and fairness in setting the valuation, making them the preferred choice for founders and investors in the contemporary startup funding landscape.
Key features and differences
The crucial distinction between pre-money SAFEs and post-money SAFEs is in the formula used to determine the conversion price, Wood said.
In pre-money SAFEs, the conversion price is set before the new investment, which means the new investors get a more significant ownership stake because the valuation doesn’t consider their investment. This can lead to a dilution of earlier investors’ ownership.
In contrast, post-money SAFEs calculate the conversion price after adding the new investment. It is more straightforward and often more fair to consider the company’s post-investment value.
This often results in a more equitable distribution of ownership between old and new investors. Post-money SAFEs are also more transparent, as everyone knows the exact ownership stake at the time of investment.
“The choice between pre- and post-Money SAFEs isn’t just a matter of semantics,” Wood said. “It can have significant implications for founders and investors. To make the right decision, it’s crucial to understand these key features and differences and consider how they align with your startup’s specific needs and goals.”
The pitfalls of pre-money SAFEs
While pre-money SAFEs were once a popular choice for startup investments, they have lost favor among founders and investors. One of the primary drawbacks is the complexity they introduce in determining the company’s valuation.
In pre-money SAFEs, the valuation is set before the new investment, sometimes leading to disputes and disagreements between startup founders and investors. The need to negotiate and establish a valuation can be time-consuming and cumbersome, Wood said, detracting from the streamlined nature of SAFEs.
It can also result in significant dilution of ownership for earlier investors, as the valuation doesn’t consider the new funding, potentially eroding the value of their initial investment. This dilution can cause concern for both founders and early investors, as it may reduce the incentives for early supporters to participate in subsequent rounds.
The shift to post-money SAFEs
According to investor Dale Wood, the transition away from pre-money SAFEs in the startup investment industry can be attributed to the desire for simplicity, transparency, and fairness.
“Investors and founders alike have increasingly favored post-money SAFEs due to their straightforward approach to valuation,” he said.
In post-money SAFEs, the valuation is determined after the new investment, which is seen as a more equitable and transparent method. This approach has resonated with the idea of fairness and has reduced the potential for disputes between parties.
“Post-money SAFEs provide a middle ground that addresses the complexities and drawbacks of pre-money SAFEs,” Wood said. “Choosing this option is a smart move for fledgling startups and their investors. It presents a more enticing opportunity.”
Factors to consider when choosing SAFEs
To help entrepreneurs better understand their choices when determining a pre-money SAFE or post-money SAFE, Wood has provided a concise checklist for startups.
- Startup stage: Consider the current stage of your startup. Pre-money SAFEs may be more suitable for early-stage startups where valuation is challenging. At the same time, post-money SAFEs are generally favored in later stages when a more precise valuation can be established.
- Investor relations: Evaluate your relationship with potential investors. If you believe a more complicated valuation process might strain these relationships, post-money SAFEs may be a better choice, offering simplicity and transparency.
- Timing: Consider your immediate funding needs and the timeline for your next funding round. Pre-money SAFEs may expedite the process, but post-money SAFEs can provide a more straightforward path for future investments.
- Dilution concerns: If you’re concerned about early investors’ dilution, it’s essential to weigh the potential drawbacks of pre-money SAFEs, as they can lead to more significant dilution.
- Legal support: Seek legal counsel to draft the SAFE agreements, as they can be complex documents. Ensure that the chosen SAFE aligns with your startup’s requirements and goals.
Guidance for Investors
Wood suggests that investors looking to evaluate the suitability of SAFEs for specific investments should begin by closely examining their risk tolerance.
“SAFEs, by nature, carry higher risk levels than more traditional investment vehicles,” he said. “Investors must be comfortable with the uncertainty and the potential for dilution in exchange for the benefits that SAFEs offer.”
Investors must also carefully assess the startup’s growth potential.
SAFEs are best suited for startups with significant growth potential and innovative business models. Evaluating the startup’s market, competition, founders’ credibility and exit strategy is essential in determining whether SAFEs align with the investor’s expectations and objectives.
Finally, investors should ensure that the SAFE agreement is reviewed by legal experts to safeguard their interests and rights in the investment, making it a prudent step in the evaluation process.
Choosing a SAFE path forward
By understanding these investment options better, entrepreneurs can make informed decisions and choose the right investment vehicle for their business’s specific stage and needs.
In the ever-evolving landscape of startup funding, SAFEs can represent the key to unlocking growth, Wood said, but only with the proper research and thorough vetting of options.
“In the world of finance, the choices we make are the pathways to our financial destinations,” he said. “When selecting investment vehicles, the importance of making informed decisions cannot be overstated.”
