Pre-post money price caps

One piece of received wisdom that, with experience, I’ve come to question is that convertible notes and their stepsiblings, Simple Agreements for Future Equity (“SAFEs”), are “simple.” Yes, the documents for these types of investments are generally quite short and deal with fewer issues, so they are (as we’ve noted in the past) easier and less expensive to generate than equity documents (which is the main reason for their popularity). However, I’ve come to recognize many subtleties in how convertible instruments operate; there’s more complexity than meets the eye.

In this post, I’d like to address one such subtlety: the difference between a postmoney and a premoney valuation cap. The difference results in resoundingly divergent economics.

The issue comes up constantly with goodcounsel’s clients because the current YCombinator SAFE form builds in a postmoney cap. (They switched from premoney in 2018.) We always need to explain to our clients (who are typically company founders) why this is disadvantageous to them. I’m always searching for the simplest possible language to use with those who (unlike VCs and startup lawyers) don’t deal every day with issues of investment valuations. Let me give it a shot here.

Mechanically, the conversion of convertible notes or SAFEs is an independent investment round that closes a moment before the “new money” comes in. When we talk about the valuation cap being expressed as premoney or postmoney, we are talking about whether this conversion round is being handled on a premoney or postmoney valuation basis. (For purposes of this post, we are assuming that there is no conversion discount.)

A company has a certain value before an equity round – think of a pie – and when new investors come in with new capital, the pie expands. The company is necessarily worth more after the new money comes in than it was before. This is reflected in the standard formula: premoney valuation + new money = postmoney valuation.

If we had $2.5M of investment under SAFEs with a $5M premoney price cap, the conversion round would have a $7.5M postmoney valuation ($5M + $2.5M). After the SAFE conversion (and immediately before the new equity round), the former SAFE investors would own a third ($2.5M/$7.5M) of the company and the founders two-thirds ($5M/$7.5M). Additional SAFE investment would not change the premoney valuation, which is fixed (because the SAFEs have a premoney cap), but would increase the postmoney; so if a new SAFE investor puts in $0.5M in addition to the $2.5M in existing SAFEs, our $7.5M denominator would go up to $8M, meaning that everyone owns a little bit less after the conversion round. This may seem obvious, but it is a key point to remember: in a round based on a premoney valuation, every dollar of incremental investment increases the postmoney and thus dilutes everyone on the cap table – both the existing investors (normally, in an early round, the founders) and the new investors.

Although we don’t normally see equity rounds expressed with a fixed post-money valuation, that is exactly what a postmoney valuation cap does in the conversion round. It’s like some sort of bizarro world that operates in reverse. By operation of the formula premoney valuation + new money = postmoney valuation, if the postmoney is locked down (because of a postmoney cap) and new money comes in, it means that the premoney valuation has to decrease. (That’s just algebra, folks!) The dilution resulting from each incremental dollar of investment through a convertible instrument with a postmoney valuation cap, therefore, impacts only the pre-money cap table – the founders – and not the new investors.

In our earlier example, if the valuation cap of $5M is a postmoney cap, then with $2.5M of investment, the SAFE investors own 50% ($2.5M/$5M) instead of a third, and the pre-money cap table owns 50% ($2.5M/$5M) rather than of two-thirds. If another SAFE investor comes in with $0.5M, the SAFE investors would own 60% ($3M/$5M) and the pre-money cap table would own 40% ($2M/$5M). Each additional investment reduces the ownership of the founders but has no impact on the other investors. Take any single SAFE investor’s investment amount and divide it by the post-money price cap – that’s going to be their ownership after the conversion round, no matter what any other investor invests.

Notice that in a premoney world, no matter how much investment comes in, the founders always own something. Not so in a postmoney world. Going back to my pie example, it’s as if the pie never grows. Each new SAFE investor simply takes another slice of the pie, and what is left over is for founders, who baked the pie in the first place. With a postmoney cap of $5M, if the founders raised $5M in SAFEs, the investors own 100% and the founders would be left with zero! Do founders understand that this bizarro world is the one that they are choosing to live in when they grab the latest SAFE off the YCombinator website? I very much doubt it.

Categorised as: Fundraising