- Kirsty Nathoo, CFO and partner at Y Combinator, discusses the importance of understanding safe notes, equity, and the company's life cycle when raising money.
- Many founders are unaware of how much of their company they have sold due to raising money on convertible instruments like safes.
- Founders should take responsibility for understanding their cap table and can use tools like spreadsheets, captable.io, or Carta to keep track of ownership.
- Kirsty goes into detail about safes, explaining that they are a simple agreement for future equity and involve minimal negotiations.
- Safes are not debt and do not have an interest rate or maturity date, but they convert into shares in a priced round.
- The anatomy of a safe is split into five sections, including what happens in different events, definitions, representations by the company and investor, and legal language.
- Founders should pay attention to sections 1 and 2 to understand how their safe works.

- The speaker encourages the audience to read and understand sections 1 and 2 of the SAFE document.
- The concept of post-money safes is introduced to make it easier for founders to understand dilution.
- Pre-money and post-money valuations are explained as different ways to express the same thing.
- The formula for calculating ownership is explained: amount raised divided by post-money valuation.
- Different types of safes are mentioned, including those with discounts, uncapped safes, and safes with a most favored nation clause.
- The most common type of safe is the valuation cap only.
- The speaker discusses the process of incorporating a company and raising money on post-money safes.
- The founders' ownership is diluted when investors come in, but the earlier investors are not diluted.
- The importance of understanding dilution and not selling too much of the company is emphasized.
- Questions are asked about authorized but unissued shares and different post-money valuation caps.

- The company has raised a million dollars and plans to hire employees and give them equity.
- An option pool with 750,000 shares is created, with 650,000 shares issued to early employees.
- This changes the cap table and the founders now own 92.5% of the company.
- However, they have also sold 15% of the company, so their actual ownership is 85%.
- The company later raises a priced round with a pre-money valuation of $15 million and a total raise of $5 million.
- The lead investor will own 20% of the company after the round closes.
- In a priced round, post-money SAFEs convert into shares, an option pool is increased or created, and new investors invest.
- The safes convert into 15% of the company's total fully diluted shares.
- The cap table shows the breakdown of shares for the safe investors.
- The founders and employees are diluted by the 15% conversion of the safes.

- The founders and employees have been diluted by 15% due to the conversion of SAFEs.
- The 5% and 10% percentages are based on the valuation cap in the SAFE.
- If the price round is lower than the valuation cap, the SAFE investors get a better deal.
- Convertible debt follows a slightly different calculation but still triggers conversion.
- Selling a high percentage of the company at a lower valuation can result in significant dilution for the founders.
- The option pool is increased to ensure 10% of post-money shares are available.
- Series A investors put in $5 million, with calculations based on pre-money valuation and capitalization.
- The cap table is updated to reflect the post-money situation, with changes in percentages for founders and SAFE investors.

- The safe investors' percentages have decreased due to dilution from series A money and an increase in the options pool.
- The lead investor owns 20% and other investors own 5% in series A, totaling 25% ownership.
- The founders' ownership has decreased from 92.5% to 51.5%.
- It is important to understand dilution and keep track of it to avoid surprises in ownership percentage.
- Convertible notes can be used to raise money, but it is recommended to avoid combining them with SAFEs.
- Pre-money safes are available but can complicate dilution calculations.
- Post-money safes are recommended to keep track of future dilution.
- Don't over-optimize for valuation caps in fundraising as it doesn't make a significant difference in ownership.
- Focus on making the company successful rather than negotiating small differences in valuation caps.

- Kirsty Nathoo, CFO and partner at Y Combinator, emphasizes the importance of understanding safe notes, equity, and the company's life cycle when raising money.
- Founders should be aware of how much of their company they have sold through convertible instruments like safes.
- Tools like spreadsheets, captable.io, or Carta can help founders keep track of ownership and understand their cap table.
- Safes are simple agreements for future equity and involve minimal negotiations, converting into shares in a priced round.
- Founders should pay attention to sections 1 and 2 of the SAFE document to understand how their safe works.
- Post-money safes are introduced to help founders understand dilution, with pre-money and post-money valuations being different ways to express the same thing.
- Different types of safes are mentioned, with the valuation cap only being the most common type.
- Dilution is explained, emphasizing the importance of understanding it and not selling too much of the company.
- The process of incorporating a company and raising money on post-money safes is discussed.
- The cap table is changed when an option pool is created and shares are issued to employees.
- In a priced round, post-money safes convert into shares, and new investors invest.
- The cap table shows the breakdown of shares for safe investors and the dilution of founders and employees.
- Convertible debt follows a slightly different calculation but still triggers conversion.
- The option pool is increased to ensure a certain percentage of post-money shares are available.
- Series A investors contribute to the cap table, resulting in changes in ownership percentages for founders and safe investors.
- It is important to understand dilution and keep track of it to avoid surprises in ownership percentage.
- It is recommended to avoid combining convertible notes with safes and to focus on the success of the company rather than small differences in valuation caps.

YC Partner Kirsty Nathoo gives the lowdown on several different ways to capitalize your company and how those impact founder equity and cap tables overall.

Transcript and lecture slides here: https://www.ycombinator.com/library/6m-understanding-safes-and-priced-equity-rounds

This lecture is part of YC's Startup School, a free online program and global community of founders. Register and join the community at https://www.startupschool.org/

Timestamps
00:00 Introduction
3:53 SAFEs
10:15 Post-money SAFEs
14:35 Dilution
22:40 Priced rounds
27:44 Priced round dilution math
41:07 Top tips
42:48 Don't over-optimize
44:08 Conclusion

I would like to introduce Kirsty, who is going to talk in much detail about safe notes, equity and the like.

I'm the CFO, 1 of the partners here at Y Combinator.

And I have now worked with probably over 1,500 companies in terms of getting them incorporated, doing our YC investment, and then seeing them through their subsequent raises, either on convertible instruments or on equity rounds.

And so this presentation is to give you some understanding of some of the things that people don't necessarily understand when they're raising money, and to hopefully help you avoid some of the pitfalls that we've seen, that some of the mistakes that we've seen founders make.

So the key message in all of this presentation is that it's important that you understand all stages of the company's life cycle, how much of the company you've sold to investors and in connection with that, how much therefore you also own.

And the thing that makes this complicated is that most companies will raise money on convertible instruments first.

And because those convertible instruments aren't yet shares, it's not immediately obvious for a lot of founders how much of the company they've sold.

So I'm going to talk through some of the mechanics of that and help you understand how all that works so that you don't get surprised when it's too late and you can't do anything about it.

So the other thing that you should also be aware of is that a lot of companies and a lot of founders will just say, oh, I don't need to worry about my cap table.

My lawyers deal with my cap table, I don't need to worry.

And actually, that's a really dangerous statement.

Again, you should make sure that you're understanding this.

It's your responsibility as the CEO or as the founder of the company to understand all of this.

And there's lots of ways that you can maintain your cap table, there's lots of ways that you can keep track of this and the simplest form is just a spreadsheet.

All it's going to show is who owns how many shares and that's it.

But there are other services out there that can help and I'll include them on a list of resources after the presentation but there's tools like captable.io and Carta which also help for you to keep track of these things.

Okay, so these are the 3 sections that I'm going to talk about.

First of all, I'm going to talk about safes.

And particularly for US companies, most companies will raise money first on safes or some other convertible instruments, which I will talk about briefly as well.

And I know Jeff mentioned the safe last week in a little bit of detail, but I'm going to go into much more detail on that and also how the sections of the SAFE works.

The S stands for simple, and so hopefully you will believe me with that and you will all be ready to understand what's going on in that SAFE as you come out of this presentation.

Then we'll talk some more about dilution again so that you can see we're going to walk through the life cycle of a company from incorporation up to raising a priced series A round so that you can see how things change over that period.

And then I'll give you some top tips on other items to do with raising money.

So let's cover what it is, and then we'll go through the details of how a SAFE is built up.

So as I said, SAFE, the S stands for simple, the rest of it is a simple agreement for future equity.

And put simply, it's a instrument where the investor will give you money now in exchange for a promise from the company to give shares to the investor at a future date when you raise money on a priced round.

There are minimal negotiations with a safe.

Really there's only 2 things that you're probably going to negotiate with the investor, which is how much money you're going to, how much money the investor will put into the company and what valuation cap.

So really those 2 things are the things to negotiate.

Whereas when you compare that with a price round, there's a whole raft of things to negotiate.

And that's what makes a price round a lot harder to close and to raise money on than a safe does.

So that's why often companies will start with a safe and then when they get to the point of being able to raise more money and they have a lead investor which they negotiate with for the price round, then the safes when they convert into shares will piggyback on the terms that has been negotiated with the lead investor in the price round.

The other thing to bear in mind is that a safe is not debt.

So some of you will have raised on what's known as convertible debt.

Debt has generally an interest rate attached to it and it has a maturity date where the debt needs to be repaid.

SAFEs have neither of those things so it's important to understand that there is a distinction between the 2 instruments but in terms of conversion in the way that they convert in a priced round, there are some similarities.

So this is the first section in the SAFE.

And this paragraph actually includes pretty much all the key details that you need to understand in a safe.

So it talks about, in exchange for payment by investor, the investor's putting in a certain amount of dollars around this date, and down here, the valuation cap is some number.

So really those 2 blanks are the 2 negotiating points.

This paragraph here is something that we've added just recently in our newest version of SAFEs.

And this is something that will hopefully help you so that once you've read our SAFE that we have available on our website once, if there's this paragraph on the SAFE, then you know that you have read the safe.

The idea behind this is that if anything changes in the safe, they can't, either the company or the investor cannot say this paragraph.

It can't say that it's the same as the safe that's on the Y Combinator website.

And so you'll know as a founder that you should be looking at it more closely to see what's been changed.

So this is just something to keep your eyes open for when you, if you receive a safe from an investor.

Okay, so the anatomy of the safe is pretty straightforward.

It's only 5 pages in length, so it's not very long.

We've tried really hard to keep the language not too legal, so it's easy to understand.

Section 1 talks about what happens in various different sets of events.

And so, most of the time, what's going to happen is there will be an equity financing at some point in the future.

And so the first part of the section talks about what happens then, how does the safe convert?

Or there might be a liquidity event, i.e.

The company might get sold before the safe converts, so it also addresses what happens if the company is sold whilst the safe is still outstanding.

Or the company might decide to close down whilst the safe's still outstanding, so it also addresses that.

So those are the 3 real key events that might drive change from the safe.

So it addresses all of those, and often we get questions from founders or from investors saying but what happens if and actually these 3 sections are the answers to pretty much all of those questions.

And then there's a couple of other sections where we clarify the liquidation priority which just means who comes first in the queue to be repaid in these different situations.

And also clarifying that the safe actually terminates, i.e.

It does no longer exist, if any of the top 3 events happen.

So that section is kind of your instruction booklet.

If something happens in your company, that's the section you look at to see what happens to your safe.

Then the next section, section 2 is just the definition section.

So anything that we refer to within the SAFE will be explained in section 2 so if you're not sure what the company capitalization definition is you go to section 2 to look at that for an explanation.

Section 3 are the representations that the company makes to the investor.

So it's saying things like the company is duly formed, it's correctly formed in Delaware.

Section 4 is the representations that the investors make to the company.

So it's things like the investor saying, yes I agree I'm an accredited investor.

And then section 5 is kind of legal boilerplate language that needs to be in there.

So, really from your point of view, the sections that you really need to understand are sections 1 and 2.

Obviously, you need to know what you're representing in section 3 as well, but those section 1 and section 2 are the key, key parts.

And that bit is only 3 pages long of the SAFE, so I'm pretty sure you can all read 3 pages and understand what's going on.

Okay, some of you may have heard in the last couple of weeks we announced to move to a different type of safe.

We've introduced the concept of post-money safes.

And it's important that we understand what post money means.

What it basically means is after all the safes have converted, what happens at that point?

And we'll go into that in a little bit more detail in a moment, but it's easy to get confused about what post money means here, but it's after all the safes.

And the reason why we introduced these is that we wanted to make it easier for founders to understand the dilution that they were taking, i.e.

How much of the company they'd sold to investors and so how much less of the company they owned.

It's a lot easier to understand that with post money safes than with the previous safes that we had which were known as pre-money safes.

Okay so, basically when we're talking about pre-money and post-money, we're talking about the same thing it's just a different way to express it, to explain it.

And so in both the priced round and for safes, the formula stays the same.

So the pre-money valuation plus the amount of money raised equals the post-money valuation of the company.

Okay, So if you have a $5 million pre-money valuation and you raise a million dollars, then the post-money valuation of the company is $6 million, okay?

And that's important to remember in a moment.

So then based on that, so that you can understand how much of the company you've sold when you're raising money on safes, the formula is just the ownership of the investors, the ownership that the investors will take is their amount raised divided by the post money either valuation in the case of a price round or valuation cap in the case of a safe.

So in our example before, if the investors were putting in $1 million and the post money valuation was $6 million, then they will own 16.67% of the company.

Does that all make sense to everybody so far?

So I'm going to talk only about safes with valuation caps here to keep things simple.

But just be aware that there are other different flavors of safes that you can use and that you may have already used or that you may find that you use in future.

So there may be the concept of a discount instead of a cap.

So instead of capping the valuation at say $6 million, it says there's a 20% discount on the Series A price.

There's also an uncapped safe which basically just says I'm going to put money in now as an investor and when you do a priced round, I'll get the same price as the priced round investors are going to get.

That's pretty uncommon because the investors who are putting in money early want some kind of bonus for putting in the money early.

So it's pretty unlikely that you'll use 1 of those.

And then finally there's a SAFE that's uncapped with a most favored nation clause, which basically what that says is, I'm not going to agree a cap right now, but if you raise some money from some other investors who do have a cap and those terms are better than my terms, I get their terms as well as an investor.

So this 1 can sometimes happen if you're raising money very early on and you don't really know what the cap is and maybe you just want to punt it for another month or 2.

But it just creates a little bit more admin for the founders because it's another thing that they have to keep track of.

So we see them sometimes, again, not all that common.

By far, the most common is just the valuation cap only.

All right, so now we understand safes and how they're made up.

We're going to talk about dilution and understanding how your cap tables work.

All right, so we're going to walk through this process.

So we're going to start with our company at Incorporation which Carolyn talked about right at the start of the Startup School course I believe.

So hopefully this will not be anything new to you.

Then we're going to talk about what happens when you raise money on safes, on post money safes.

Then we're going to talk about what happens as you hire people and start to issue equity to employees.

And then the company is going to do a price round and so what happens to the cap table at that point?

And now I'll warn you, this is starting to get into the math section of the whole thing so turn your brains on and keep concentrating.

All right so incorporation, So let's just assume it's a really simple company.

There's 2 founders and they split their shares equally between the 2 of them.

So in this example, each founder owns 4.625 million shares.

So there's a total of 9.25 million shares issued and each founder owns 50%.

And so at this point in order for them to own those shares the founders have done the paperwork, they've granted those shares through a restricted stock purchase agreement and there's vesting on those shares as was talked about with Carolyn earlier in the course.

So then the next thing that's going to happen is this company raises some money on a post money safe and they raise from 2 investors.

So the first investor comes in quite early and they put in $200,000 at a $4 million post money valuation cap and then a little bit later on, investor B comes in, puts in $800,000 at an $8 million post money valuation cap.

So if you remember back to our formulas, the ownership that investor A has at this point is their amount of money that they've put in divided by the post money valuation cap, which gives them 5% of the company.

Same for investor B, 800,000 over 8 million, which gives them 10% of the company.

So in total, the founders at this stage have sold 15% of the company.

So Even though this doesn't change the actual cap table, because these aren't shares at this point, this is just a safe, this is just a promise to give shares in future, the founders should know at this stage that they have sold 15% of the company.

And if they've sold 15% of the company, then they can no longer own 100% of the company.

So now instead of the founders owning 100% of the company between them, they've been diluted by the 15%.

So they're going down to 85% of the company.

So it's important to have that in your brain when you're raising money, because whilst the cap table, like I say, doesn't change, the fact that you've just sold 15% of the company is an important fact, and it's an important thing to know because you want to make sure that you're not selling too much of the company because you know that there's a lot of future fundraisings that are going to happen with the company and therefore there's going to be more future dilution.

Is everyone happy with how we've got to that 15%.

So the founders are the only ones getting diluted at this point.

So the question is, it's only the founders that are being diluted at the moment.

Because that's the construct of the post money safes.

The latest safe investors don't dilute the earlier safe investors.

It just dilutes the existing shareholders and at this stage it's just the founders who are the existing shareholders.

Does it make sense to have shares in the treasury so that they can cover the anticipated diversion?

does it make sense to have shares authorized but unissued, I think is what you mean.

So at this stage, it doesn't necessarily make a difference as you'll see in a moment, you actually create new shares that you're going to issue to these safeholders when they convert.

So at this stage, it's fine to just have the shares that the founders have and maybe some that you want to give out for hiring.

Why index claim B has different post money valuation cap?

Well in this example, so the question is why do they have different post money valuation caps?

And so in this example, it could be for any number of reasons, but in this example, we're assuming that this 1 happened maybe a month after incorporation and maybe this 1 happened 6 months after incorporation and more has gone on in the company and so there's slightly less risk and so the company's been able to negotiate a different cap.

But things change through the company and it's totally fine to have different caps because as you can see from here, you just calculate everything separately and then add it all together.

Okay, so, company's raised a million dollars.

First thing it's probably going to do with that money is hire some people.

And when you hire employees, you're probably going to give them some equity.

And so in this example, the company creates at this stage a option pool, otherwise known as an ESOP or an employee incentive plan.

And in this example, they have created a plan or a pool that has 750,000 shares in it, and they've issued out of their 650,000 shares to early employees.

So this has now changed their cap table because they've issued shares and so the fact that there's more shares being issued means that the cap table changes because we now have more shareholders.

And so Now we have a total of 10 million shares that have been fully diluted, basically means the combination of issued and set aside in the option pool in this case.

So Now we have our founders, instead of owning 100%, have 92.5% of the company, and the option plan in total is 7.5% of the company.

So these founders don't actually have 92.5% because they have also sold 15% of the company.

And so actually, they own less than the 92.5%.

They've actually, they actually own 85% of that, which is about 78.6%.

So again, this is where it gets dangerous for the founders.

If they forget about the safes, the founders are sitting there saying, well, I own 92 and a half percent, this is great.

I own still loads of the company and they have forgotten about the safes and the dilution they're about to take from that so again it's really important to keep track of how much you've sold on your safes so that you can do that calculation and say, actually I don't have 92 1 1 2%, I have 85% of that because I've sold 15% of the company.

But it's also, these numbers have been diluted by those safes as well.

So as you'll see in a moment, these numbers change as well.

Okay, so now we're going to fast forward about let's say a year.

The company is doing well, it's raised a price round and it has a term sheet for the price round which says that the pre-money valuation of the round is 15 million dollars and they're going to raise a total of 5000000 dollars of which the lead investor, which is the investor that they do all of the negotiations with, is going to invest $4 million.

And so if you remember from our formula at the start, the post money valuation is the pre money valuation plus the total raise.

So the post-money valuation is 20 million.

The other thing that gets negotiated as part of the priced round is the option pool increase.

So generally what happens is that the investors in the series A will say, okay, we're gonna put some money in.

We know that this money is going to go towards hiring.

So we want you to create an option pool for all the new employees that you're going to employ and give equity to in advance so that it's sitting there ready for those employees.

And so usually you see that the the option pool is about 10 percent, it might go up to about 15 percent but anything more than that is fairly non-standard.

Is the 10% coming from founders or collectively?

So the question is, is the 10% coming from founders or collectively?

And you'll see in a moment, it's going to dilute the existing shareholders and the safeholders, but it doesn't dilute the new money.

So how is the option pool represented on the cap table?

Is it represented on the cap table or what form does it take?

So the question is how is the option pool represented on the cap table?

So if we go back to here, we just show it so that we have the options available from the pool that haven't been issued is a line and anything that has been issued from the pool is a separate line.

The reason why we show those 2 things separately is that these shares are considered outstanding, they're considered issued, whereas these aren't.

And so that's the difference between what, that's what fully diluted means.

It means outstanding shares, which are these 2 lines, plus any shares reserved under the option pool.

All right, so quick maths question for you.

What do we expect that the lead investor will own?

What percentage of the company do we think the lead investor is going to own after the round closes?

20%, yeah, for the lead investor, 25% in total for all of the series A investors.

Because the lead investor is going to put in $4 million divided by $20 million gives 20%.

So you'll see in a minute in the cap table that that all works through in the calculations but it's always good to just do that quick check so that you can sense check what's going on in your cap table.

Alright so in a priced round where you have or where the company has raised money just on post money safes and then has raised a priced round, 3 things will happen.

And these 3 things happen at the same time in terms of the documents but in terms of the calculations it's important that the order is correct.

And so the 3 things with post money SAFEs is that the first thing that happens is the SAFEs convert into shares.

Then an options pool is increased or created, if there isn't 1 already, and then the new investors invest.

And you'll see in a minute how that all works through with the calculations.

Now 1 other thing that starts to get a little bit confusing here is 1 of the sort of the lingo of how this works is that often the lawyers and the founders will talk about the SAFEs being included in the pre-money and what that's basically saying is that when the new investors invest and they calculate their price per share the calculation includes the shares from the conversion of the safes so even though the safes themselves are referred to as post money safes.

That's talking about how the safes convert.

This sentence where the safes are included in the pre money is talking about how the series A price is calculated.

So it gets a little bit confusing because it's talking about post money and pre money, but that's just something to bear in mind when this happens.

And obviously at the time that you're raising a price round, you're going to have a lot of advisors, you're going to be working with lawyers who can explain all of this to you as well.

All right, let's go through these 3 steps then.

So, the first step is our safes are going to convert.

And we already know, because we've already done the calculation, that these safes are going to convert into 15% of the company.

And so 15% of the company means 15% of the total fully diluted shares, both common shares and preferred shares.

So investors get preferred shares which have a different set of rights and privileges than the common shares, which is what the founders and employees get.

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Understanding SAFEs and Priced Equity Rounds by Kirsty Nathoo