Raising A SAFE Or Convertible Note In Between Rounds

A trend we’ve seen in the financing of startups in the last five years is the “SAFE between rounds” which means raising a convertible note (or SAFE) to provide more capital and runway in between financing rounds. It often comes in the form of an offer by an investor who missed the last round and doesn’t want to miss the next round.

It is a tempting offer because there is no immediate dilution from the capital and it usually converts at the next round price or a small discount to it.

Most founders look at the offer and think “why not?”

Here is why you might not want to do this.

The SAFE or convertible note can “crowd out” new investors in the next round and make it very hard to find a lead investor or any high quality investors.

Let’s do some math to show how this happens.

Let’s say you did a seed round of \$1mm where you sold 15% of the company and you did a Series A of \$3mm where you sold 20% of the company. Your last round valuation was \$15mm post-money and you’ve now sold ~35% of the company to investors. These investors will typically have “pro-rata rights” to participate in the next round. Which means 35% of the next round will go to your existing investors.

Let’s say you hope to double your valuation on your next round and raise a Series B at \$30mm pre-money or more in a year to 18 months.

Then someone comes along and offers you a \$2mm convertible note or SAFE which converts into the next round. You think “free money, that sounds great.”

But if you take the note, then you have a fair bit of the next round already committed for.

Let’s say the next round is \$5mm. The existing investors take 35% of \$5mm (or \$1.75mm), the note takes \$2mm, and you are left with \$1.25mm to offer a new investor. It is very hard to find a lead investor who will price the round for only \$1.25mm of a \$5mm round. And if that round is at \$30mm pre-money, \$35mm post-money, you are only offering that new investor 3.6% of the company which is not a lot.

Let’s say the next round is \$7.5mm, a reasonable amount to raise at \$30mm pre-money (20% dilution). The existing investors take \$2.625mm, the note takes \$2mm, and so you have \$2.875mm to offer a new investor to lead and price the round. That is a fairly small number as well and would only purchase 7.7% of the company.

You’d have to raise a \$10mm Series B before you’d be able to offer a sizable allocation to a new lead if you have 35% of the round committed to pro-rata rights and a \$2mm note converting into it. And even then the new investor can only purchase ~11% of the company and the round will be 25% dilutive at \$30mm pre-money.

As you can see, taking a SAFE or convertible note between rounds can make it hard to create enough of an allocation in the next round to attract a high quality lead who will price the round.

So, if taking a SAFE or convertible note between rounds is not a great idea, what should a founder do?

I like to see if the investor who wants to do the SAFE or convert is interested in catalyzing a “Series A1” where you take their money and the pro-rata (or slightly more) from the insiders and price it at a significant markup to the Series A. If they are willing to do that, it often is better for everyone to do that.

That tends to be less dilutive, creates even more runway to get to an attractive B round and it avoids the issue of crowding out money in the next round.

1. Pointsandfigures

On the flip side, often the startup doesn’t quite have the traction yet to support the higher valuation. I 100% agree with your analysis. I dislike SAFEs and Convert Debt even at seed because most of the time it’s just two parties avoiding a difficult valuation discussion.One of the tough things for Founders is in that first seed round it can be very hard to find a committed lead. So they have to string together a series of checks. That can set them off on the wrong foot for their corporate finance from the start.Financing your company is no different than putting together an operations plan or a marketing plan. It is a strategy like anything else in the business. I’d really suggest everyone read and understand the book Venture Deals so they know how the other side of the table is thinking. If you haven’t, go through the online videos. They are great.The math on the VC side is hard and unforgiving: Invest at seed at higher than \$8MM pre and your expected IRR drops from roughly 40% to 20%. To pay LP’s; ownership percentage times exit value divided by amount invested….and there is a liquidity price to be paid since the capital is locked up for a long time compared to other alternative investments.

You hid the gem of your post in the middle! Venture Deals is an incredible resource.

2. BillMcNeely

So it’s like credit card money. You get the money now but cost a lot later when great investors can’t get in.

3. RiganoESQ

sure but you are assuming that markets are perfect and capital is being thrown at founders from every which direction, all while they are running their co. it would be interesting to see some posts from founders perspective as opposed to always VC … would add good perspective & diversity

1. PhilipSugar

We agree, a high class problem. Most founders are doing anything to raise capital. I could be coarse but let’s just say anything. See my comment.

4. Guy Gamzu

I guess some founders may view SAFE as a ‘why not’ opportunity, but I think this is the exception to the rule. In most cases I come across – especially for post seed – the founders desperately need the cash and look for ways to get it with minimal friction. Some of the SAFEs are actually from existing investors… In the Israeli ecosystem ‘healthy’ rounds dilute 20-25%. In the example above (\$30 pre) it would mean \$7.5-10M. Assuming part of the \$2m are existing, it still makes a lot of room for a lead.

5. Frank W. Miller

The more likely scenario is the founder’s are looking to extend runway for whatever reason, probably because they can’t raise another round at that moment. So some opportunistic funding source comes along and offers them a convertible note to take advantage of them at a time when they are in distress. Not only does it mess up the next round but its a convertible note, gutless on the part of the investor who is squeezing the founder’s for all they can get.

1. PhilipSugar

Not gutless if it is just a nice word for “bridge round” which is a nice word for terms that are essentially go out in the prison yard and get raped, when you can’t convert.I always worry when I hear some nice acronym like “SAFE” because it probably has a true meaning of opposite. Nobody would call it “DANGER”

2. LE

gutless on the part of the investor who is squeezing the founder’s for all they can get.Gutless? Please expand on this if you can. Are you implying that there is something negative about an investor trying to make money? Other than reputation (which in some cases doesn’t matter) why shouldn’t they do that?

1. Frank W. Miller

Its gutless because the investor is typically hitting the owners with these terms they would never take unless they were in distress. They’re hitting them when they are down.

1. LE

I am not an investor and have no dog in this fight. But business wise that is kind of the way it works so you have to take it in context. It’s not the investors responsibility to make a situation right for someone they are investing in or not take advantage of an opportunity if they can (up to a certain point and that point varies by person). It’s business. Just like in sports you do things that you don’t do IRL or at the Church.As a general rule will point out what I say does not mean how I would operate in any particular case. Can’t say what I would do. Generally though I will exploit a situation to my benefit. That is the way it works.Here is a unrelated example. Years ago I had a guy doing work for me on the side that also worked for AOL. At one point he couldn’t get my work done. Literally ‘I am doing work for AOL and they are more important than you are sorry’. Well he still did work but obviously prioritized AOL. Well what happens? AOL lays him off. Then all the sudden he needs money. What do I do? I advance him \$3000 for work that he hasn’t even done yet. Point being I understood that AOL was more important than I was and I didn’t hold it against him. Sure it bothered me of course. [1] He is still doing things for me today (and this happened a long long time ago…). Right now he works for a FAANG company.[1] I also got him interviews and spent a great deal on the phone with him and convinced him to take his current job even though it wasn’t necessarily good for me to do so. I saw an overall benefit from that behavior that outweighed any negative to me personally.

2. jsrand

In my experience, it’s pretty rare to find an outside investor who would propose to come into a company on a SAFE or convertible note once the company has done a priced round. Those kinds of rounds are far more likely to be offered up by the company. Founders tend to have more favorable views of convertible notes and SAFEs than investors do, especially institutional investors.

6. PhilipSugar

Here is the thing from the Entrepreneur perspective.Entrepreneurs, know this: When a financial person comes at you with an “interesting” new way to finance you…….you better look closely.I am not ascribing malice, but I would love for Fred to comment on what are the terms of that “convertible note” if it does not convert at a price above the current valuation (he has much more info than I do) Everything you do other than straight equity has the possibility to come back and bite you in the ass. HARD.This is where Fred and Brad have been invaluable. I’ve learned this the hard way. You can learn the easy way.Entrepreneurs understand this……there is a good chance that not only don’t you know the rules of the game, you don’t even understand what game is being played.Let me end with a story. I had to go with my Dad to buy a new car. I finally told him he could get a new one and drive or keep the old one and not drive, when it broke down again don’t call me get a cab.I of course had all of the info and told the salesman this will be the quickest transaction you will ever have I am either going to buy or leave in the next 5 minutes. I give you this car (I did not want to sell an old unreliable car) and this check and take that car from your lot.Well he agreed, but what happened is that we got way more for the old car and paid full list for the new one. Now my Dad was worried that we “ripped the car dealer off” because the old car sucked, he actually fainted in church the next morning because he couldn’t sleep. After much cursing (my Dad was mortified as the priest heard) I actually looked into.The car dealer wanted us to pay full list as that gets recorded for True Car in the price they give to you to buy cars. Toyota actually spiffs the dealer for selling above a certain price.So you think you know the game?

1. falicon

You do get a medal for coming in last at work: severance, UC, and a rec letter ๐

Simon touches on something that it’s own beast, shareholder primacy. Lynn Stout’s book on this is an educational dive into the laws and theories that gave rise to shareholder primacy. Check it out

3. JamesHRH

He’s bang on.But I do think that being aware of the problem is 1/2 the battle. Baby Boomers’ kids can fix the garbage hand their parents left for them.What he is missing is that 1/3 of people are in a personality cycle that values social status. It is an infinite game for humanity.Service to others creates meaning; service to self creates nothing.

4. PhilipSugar

I liked the whole discussion of finite versus infinite companies.what that means for strategy. His four points were great. But when he ends saying Millineals its not your fault after spending thirty minutes saying why everybody is a winner is bad you lost me.

1. falicon

I just liked the title, related to this discussion. ๐

1. PhilipSugar

I think it is a good video, I recommend watching it. He is much more articulate than me. I loved his video “Getting to Why” I always would say why are we doing this? And I would get here is what we do and how we do it. Why do we do so many powerpoints? Well here is what our templates are and how we do them, but why?I have also talked about playing the finite game and infinite game of business but not in such simple terms. You see this when a founder gives up control to a mercenary. I like to use the Home Depot example. One is in it for the long haul, the other wants to make the “numbers”

2. LE

I of course had all of the info and told the salesman this will be the quickest transaction you will ever have I am either going to buy or leave in the next 5 minutes.Well as I have discussed in chapter 9 (of the book that I will never write) the way to get the best price in a car negotiation (or in most negotiations) is to waste more time of the salesman not make it quick deal. More commitment by a party means less chance to back out of an offer. Kindo of a basic principle. Now I can fully understand why you didn’t want to waste time playing the game and just wanted a quick and dirty deal. But the more time wasted on something (honestly buying anything) the less likely either party will walk away. Human nature. (By the way I can give situations where this doesn’t apply however the way you stated does not seem to indicate you are doing any of those). Now my Dad was worried that we “ripped the car dealer off” because the old car sucked, he actually fainted in church the next morning because he couldn’t sleep.That is really sad. Was your dad always like this? Is this age related?The car dealer wanted us to pay full list as that gets recorded for True Car in the price they give to you to buy cars. Toyota actually spiffs the dealer for selling above a certain price.There are tons of things in business just like that. Here is another one. Never assume that someone who asks for cash is cheating. That is the obvious thing everyone thinks. Maybe not. Maybe they want you to think that is the reason they are giving you a lower price. Not just because you asked which would imply they were overcharging you.

1. PhilipSugar

Well you like your way I like mine. I bring a check already made out to the dealer. I have ripped one up before. You always talk about valuing your time, although I believe you find it entertainment.Yes, age related and my mother has been gone. They called me and I was asking him if his head had gone f’ing soft. The sales guy we dealt with had all sorts of awards on his desk. He even told my Dad to tell people at morning mass that they were the place to go to.

2. cavepainting

This is unfortunately very very true in M&A. The more time a buyer spends with the team, the more they are inclined to do a deal vs. walk away.Thus red flags that should have normally torpedoed many a deal get brushed under the carpet because there is a deal frenzy and a desire to get something done — This is especially so if executives get their ego wrapped into the deal.This is exactly what happened with the HP acquisition of Autonomy (for \$10B).

In poker, it’s called being pot committed.

1. PhilipSugar

In business it’s called a sunk cost. I know they hammered that into your head at Wharton.It is a trap I see people fall into all of the time. I am even tempted at times.

The psychology of it is so pernicious, it’s devilishly hard to overcome.

3. PhilipSugar

In so many ways. Ultimate form is gambling. But I have seen it a ton especially as organizations get bigger.

2. LE

Behavior covers a wide swatch of situations. Another (among many) is prosecution of criminals. Also personal relationships. [1] Part of it has to do with admitting you were wrong about initial thoughts or acknowledging that you ignored knew but ignored them.Goes w/o saying that it’s not as simple as it ever sounds for most people.[1] re: relationships (really of any kind) a) ‘get out while you can’ and b) ‘don’t enter into a situation that upfront does not appear it can work for some reason under the ‘well you never know’ assumption’.

3. cavepainting

Every transaction or relationship is a gameWhere each one is playing by their own set of rulesThe ones who do not pause to askwhat the other person might be solving forGet bad deals because they were playing blindBut the ones who do not pause to askwhat they themselves were solving forare the ones courting real disaster.

1. PhilipSugar

I agree with you completely about M&AI wanted quick and painless with a good not the best possible.I would add one other. If you try to play by somebody else’s rules you will lose.

1. LE

I would add one other. If you try to play by somebody else’s rules you will lose.Mainly if you break it down because it’s a creative pursuit at the core and as such you need some kind of emotion and interpretation of signs involved that allows you to adjust to the specific situation. On the fly. Not to over-complicate things but here is an example. [1]Let’s say someone follows your rule of ‘be prepared with check; be prepared to rip up check’. So they walk in being pre-programmed to follow Phil’s advice. What works for Phil. It’s the first time they try it. However maybe there are cases (even 3 out of 10) where Phil himself picks up a signal (showroom activity, salesman’s face who knows) where he doesn’t even do that (see [1]). So they use the strategy and they lose. Likewise someone follows my way of doing things. But maybe there are cases where I don’t do what I say I do given how I read ‘the rest of the people at the table’. It’s creative and all based on interpreting signals. I often alter a strategy on the fly or on a whim based on some micro information that I pick up on. Can point to one case where over the phone I heard a voice tone and jacked up something in price and made out extremely well. Most people wouldn’t hear what I heard (know this for a fact that I am good at that and have that micro tone and micro expression skill).This is really the danger of a world where people read internet advice out of specific context and w/o seeing what the skilled practitioner sees at any given moment which guides how they act.[1] Ok I guess it’s similar to stock buying advice. You need to also know when to sell.

1. PhilipSugar

There are always exceptions. That is why it is called advice not law, and it’s worth what you paid me for it.I’ll give another piece of advice: If you get an unexpected RFP and it has a quick turnaround date, and says don’t contact anybody from the company, unless you are able to talk to the decision maker don’t even bother to respond, or spend five minutes and give a price, with the hope of blowing up the company that wrote the RFP for the potential customer.You are purely column fodder. You will be in column 2, 3, 4, only to be mowed down.Sure there are exceptions to this rule, somebody has to have it fast for a specific reason, maybe a government contract.But if you play by the rules: Well it says fill this whole thing out by this date and don’t talk to anybody, you have valued your time at exactly zero.

4. Mark Essel

Dig it.When I went car shopping this past weekend it was to check if I fit into the cars and then feel how they drive. If I found one I loved, I’d buy it without much negotiation although that trade in + check move sounds solid.

7. Eric Di Benedetto

A SAFE can provide the fuel for accelerating the growth that will be the catalyst for a new round at a mark-up. In such cases, it helps improve the chances of closing another round with much better terms…

8. Dara Albright

With technology and regulations creating much more innovative paths of capital formation, in time, traditional venture capital rounds may not be the most favorable or even necessary. I believe we are to about to enter the most inventive & revolutionary era of corporate finance. It’ll be interesting to watch it unfold.

A friend is going through this right now. In this case, the B+ (everyone wants their own term) round ballooned from \$10M to \$30M. If they close this bridge, I believe the company won’t be able to raise another round and will be forced into a sale.

How does the math change on a bridge round if a lead investor is part of the source of funds?

11. Chris Harvey

If you’re raising from one or two lead investors, then pro rata seems mandatory, but for those who are closing their Series Seed (or Series A), the non-major investors should not have pro rata rights. And, with the new YC Post-Money Safe, safe holders shouldn’t have pro rata rights. Of course, if you’re a VC firm like USV, pro rata rights are non-negotiable. Something to bear in mind!

12. Kashif Rayani

I created a cap table model that illustrates the math. let me know if there are any questions/comments/thoughts. https://t.co/E36S2xYyHJ

1. Pointsandfigures

13. wbho

I created a very simple spreadsheet here to experiment with the concepts described in this post. It includes sensitivity tables and shows various Series B investor stakes under different raise scenarios

14. Ian Hathaway

Not to mention when companies have multiple stacked notes

15. jsrand

Fred’s math assumes that you are using the SAFE/convertible as a sort of “advance” against the next round, and the money you raise reduces the cash you will need to raise down the road. So the \$7.5 million round he uses as an example is really a \$5.5 million round (although the press release will probably say will call it a \$7.5 million round). If you are on top of your cash situation, you could use the SAFE/convertible note as a test case for upping your valuation (via a higher valuation cap, which for better or worse many investors in the current market seem to see as a proxy for a pricing), and use that cash to further build your valuation and push off the next round for at least a few months. At that point, you reassess your cash needs and then maybe go out for a \$7.5 million round, hopefully at a higher valuation than you would have raised at had you not done the SAFE/convertible. I’m not sure how this is all that much different than the Series A-1 approach – assuming the company knows how to manage its cash properly.

16. Gustavo Vizcardo

Fred, please could you make an example of your last proposal? => I like to see if the investor who wants to do the SAFE or convert is interested in catalyzing a โSeries A1โ where you take their money and the pro-rata (or slightly more) from the insiders and price it at a significant markup to the Series A. If they are willing to do that, it often is better for everyone to do that.

17. VincentWright

Wow… I know of at least 4 sets of professionals who should read this, *today*… (As always: Thanks, Fred…)