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Understanding SAFE note dilution when fundraising

By Joanne Hue, Date published: 2023-01-23

SAFE note dilution
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A SAFE note is similar to an option or a warrant that allows the investor to purchase shares in the company. Unlike debt, the founder of the company does not need to pay interest to the investor while using a SAFE note. It provides startups the capital required to take off and incentivizes larger investors to take up the risk of investing in bedding startups. As SAFE notes do not accrue interest, startups tend to prefer them over convertibles. 

Building capital is an intrinsic process of developing a business- this is also known as fundraising. As observed in SAFE note exchanges, selling shares to investors is one of the many practices of fundraising. Companies exchange shares for cash from investors. When the outstanding shares or the whole of shares held by shareholders increase, the percentage ownership of an individual shareholder decrease. This process is known as dilution in fundraising. A dilution does not mean that a shareholder is losing anything. It means that the size of the company’s capital is increasing. 

During the process of fundraising, a company intends to amass its required capital. This means that the SAFE notes of early investors will be diluted with the addition of newer investors and the purchase of more company shares. For both entrepreneurs and investors calculating the potential dilution of their equity after the fundraising is necessary to ensure they still have the intended percentage of ownership in the company.

What is dilution?

During expansion or fundraising, a company may issue new stocks. As the number of shareholders increases, the percentage ownership of each shareholder decreases. The process is known as dilution. Dilution may occur either from issuances of new shares or from investors exercising their rights to purchase stock. More shares result in a dilution of percentage ownership to each shareholder.   

 The dilution of shares can impact founders and shareholders. In the event of dilution, founders may end up losing control over the startup. This is because the dilution of shares reduces their percentage ownership and votes simultaneously. This means they will have a lesser say in the decisions of the company. Likewise, due to reduced dividends per share, they may end up with their profit gain also reduced. 

For investors, the dilution of equity reduces the value of their investment. Provided the newer shareholders own the larger stocks in the company, the investors may also end up losing their decision-making leverage in the company. In some circumstances, investors with larger stocks may take advantage of smaller investors. 

 How does SAFE note dilution work?

With SAFE notes, investors have the option to postpone the dilution of their stocks until the next financing round. Various factors affect the dilutive extent of SAFE notes. Conversion discounts and Valuation caps have an important role in determining the impacts of dilution. If your company’s valuation cap is higher for the following financing round compared to the initial ones, then initial investors will receive a lower price per share.  Likewise, with conversion discounts, your investors acquire a discount on the price per share when exchanging their SAFE note for equity. 

The impact of dilution is also a determinant of whether investors have pre-money SAFE notes or post-money SAFE notes. Pre-money SAFEs tend to be less dilutive for investors because the percentage ownership of each investor is unknown until the next round. In the case of Post Money SAFEs investors lock in their ownership percentage before newer investors arrive. Investors prefer this despite its higher dilution because it clarifies the doubt concerning the company’s proportional ownership. 

Strategies for mitigating dilution

SAFE notes dilution can be controlled through proper planning and careful modeling of future dilutions. Before going through the process of fundraising, a company should model the prospective impacts of dilution. You can achieve this by using a CAP table. A CAP table is a collective analysis of a company’s ownership percentage, rounds of investment, the value of equity, and equity dilution.

To avoid the negative impacts of unexpected dilution, it is suggestible to not raise funds in excess. Fundraising should account for the company’s financial requirements in the upcoming stage. Estimating the long-term results is critical, therefore, the process should not be rushed. Finally, to mitigate the impacts of dilution, founders should avoid hyper-reliance on SAFE notes. Ascites are designed to benefit investors, and unreasonable use of notes may be disadvantageous for the founders during dilution.

Conclusion

A SAFE note is an incentive for investors to invest in new startups that are in need of funds. The founders do not need to repay interest to the investors in exchange for the investments. SAFE notes allow investors to exchange their notes in exchange for company equity. Similarly, dilution occurs when the company allows newer investors to fund the company. As the number of shareholders increases, the percentage ownership of an individual investor decreases. This leads to a dilution of the stocks. 

A SAFE note dilution is impacted by factors such as the pre-money and post-money SAFE notes, valuation cap, and conversion discounts. An uncontrolled dilution can have detrimental effects on founders and investors. In order to mitigate it, companies can model their dilution, limit their option pool, and account for the company’s financial requirements before raising funds.

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