UNDERSTANDING CAP TABLES: NAVIGATING THE IMPACT OF SAFE'S ON THE CAPITALIZATION TABLE

As a startup founder, managing your cap table effectively is crucial when it comes to raising funds and attracting venture capital ("VC") investments. Understanding the impact of issuing Simple Agreement for Future Equity instruments (commonly called SAFE's) on your cap table is especially important. In this blog post, we will explore the implications of issuing SAFE's before a priced round selling preferred stock to a VC firm, including the potential introduction of shadow series of preferred stock.

Purpose of the Cap Table

A cap table is a vital tool for understanding the ownership and equity structure of a company. It tracks the distribution of equity and ownership stakes among various securities issued by the company, such as common stock, preferred stock, options, warrants, and convertible securities. Maintaining an accurate and up-to-date cap table is essential for making informed decisions and managing equity dilution.

SAFE's

A Simple Agreement for Future Equity ("SAFE") is a financing instrument commonly used by early-stage startups. SAFE's allow startups to raise capital quickly, without the immediate need for setting a valuation and without charging the company interest. As an investment contract, a SAFE provides the investor with the right to obtain preferred stock by means of the conversion of the SAFE into equity (typically preferred stock) upon a predefined trigger event, such as a subsequent financing round, sale of the company, or the company's dissolution. 

Impact of SAFE's  on Cap Tables

Issuing SAFE's can impact the ownership structure and dilution during subsequent financing rounds, particularly when a VC firm enters the picture. Let's now examine how different terms of SAFE's and their conversion can introduce shadow series of preferred stock into the cap table.

Effect of Issuing SAFE's before a Priced Round

When a startup has issued SAFE's prior to a priced round (selling preferred stock to a VC firm), the conversion of SAFE's typically results in the creation of one or more different series of preferred stock, commonly known as "shadow series." Here are some key considerations to take into account.

1. Conversion Price—The conversion provisions of the SAFE will determine the conversion mechanics and shares issued when a priced round occurs. The number of shares issued when a SAFE converts will be based on the applicable conversion terms, such as the valuation cap or discount rate.
2. Shadow Series Preferred Stock—In a SAFE instrument, the preferred stock to be later issued to the new-money investor (the VC firm) is often referred to as "Standard Preferred Stock," while the Preferred Stock to be issued to the SAFE holder on conversion is referred to as "Safe Preferred Stock." Safe Preferred Stock is also commonly referred to as "Shadow Series Preferred Stock." By whatever name called, the two series are made distinct because, although the Shadow Series will be identical in all other respects to the Standard Preferred Stock, for the Shadow Series, the calculation of its respective liquidation preference, conversion price, and dividend rate will be based on the price per share of the Safe Preferred Stock itself (that is, on its Conversion Price). Those same provisions for the Standard Preferred Stock will be based on the per share price to be paid for the Standard Preferred Stock by the new-money investors.
3. Multiple Shadow Series—If multiple SAFE's have been issued to early investors with different valuation caps and/or discount rates, the effective Conversion Price of each one will be different. The Conversion Price is effectively the purchase price to be paid by SAFE holders for their respective Shadow Series Preferred Stock, and is the price at which the SAFE instrument will "purchase" (by conversion) such preferred stock. So, for example, imagine a priced round where a VC firm purchases Series Seed Preferred Stock for $1 per share, and there are two early Angel Investors who each purchased a $50,000 SAFE, one with a 20% discount and the other with a 25% discount. The Conversion Prices for the two SAFE's would be $0.80 and $0.75, respectively, the former "purchasing" (by conversion) 62,500 shares of one shadow series (lets call it Series Seed-1 Preferred Stock) and the latter 66,666 (rounding down) shares of the second shadow series (Series Seed-2 Preferred Stock). In this hypothetical, there would be three distinct series of preferred stock: the Standard Preferred Stock issued to the VC, and the two shadow series issued to the SAFE holders.
4. Negotiating VC Terms—The existence of outstanding SAFE's with different conversion terms can complicate negotiations with VC firms and add time and cost to the deal process.
5. Complexity—The introduction of multiple SAFE's resulting in diverse shadow series can also lead to complexity in calculating dilution and understanding ownership percentages.
6. Impact on Founders' Ownership and Control—These complexities can come home in a rude awakening for the founders if not careful. Conversion of SAFEs affects the founders' ownership and voting rights, because, of course, each conversion results in the issuance of more shares of stock to investors. Keeping track of that can be time consuming. If overlooked or ignored, it can result in a shock when numerous SAFE's with different terms convert, in particular if the founders agree too eagerly with early investors' requested (or demanded) valuation caps.

Managing Cap Table Implications

To effectively manage the impact of SAFE's on your cap table, consider the following:

1. Early Negotiations—When negotiating with angels or other early investors before a company can be given a valuation, care should be given to not simply accepting a requested or demanded valuation cap in a SAFE. It is fair for early investors to receive a benefit in exchange for the risks they take by investing in a company before its operating history or pipeline can support a valuation. But, often a valuation cap is arbitrary and can result in extreme and unfair dilution to the founders. It can also impact negatively on the company's negotiations with VC's in subsequent priced rounds.   
2. Comprehensive Record-Keeping—Maintain detailed records of all SAFE issuances, including the terms, conversion mechanics, and any potential shadow series that may arise upon conversion. Be sure to review them periodically to avoid the "out of sight out of mind" problem.
3. Cap Table Modeling—Utilize cap table management tools or seek guidance from legal professionals to accurately model different dilution scenarios based on the conversion mechanics and terms of the SAFE's. This will help you understand the potential impact of shadow series on ownership and control.
4. VC Negotiations—When negotiating with VC firms, founders must transparently communicate the existence of SAFE's with different terms and their potential impact on the cap table. Seek advice from experienced legal professionals to ensure fair and favorable terms for all parties involved. In this connection, founders should not simply accept the first VC term sheet presented, but should review it with legal counsel and, if appropriate, the startup's certified public accountant.

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