It’s important to grasp general legal concepts and definitions as a startup founder. This page is sourced from Clerky’s Legal Concepts for Founders page.
The most popular replacement for convertible notes are safes (short for simple agreement for future equity), created by Y Combinator. Like convertible notes, safes can convert into preferred stock.
There are three major types of safes - safes with a valuation cap, safes with a discount, and safes with both. These correspond to the three major flavors of convertible notes.
The number of shares of preferred stock a safe will convert into is determined by dividing the amount of the safe investment by a price (per share) for the preferred stock. The lower this price is, the more shares a safe will convert into. The higher this price is, the fewer shares a safe will convert into.
If the investment amount for a safe with a valuation cap is $1 million, and the price per share used for conversion is $2.00, the safe will convert into 500,000 shares by default.
When a safe has a valuation cap and the safe is converting into preferred stock as a result of a preferred stock financing, there are two ways of determining the per share price of preferred stock to use for the safe conversion. The first is to use the per share price of preferred stock from the preferred stock financing. The second is to calculate a price by dividing the valuation cap by the fully-diluted capitalization (referred to as company capitalization in safes). Safes convert using the lower of these two possible prices, making the valuation cap a limit on the valuation that is used for the conversion.
If the valuation cap for a safe is $20 million, the fully-diluted capitalization of the company is 10 million shares, and the price per share of preferred stock in the preferred stock financing is $3, then the price per share used for converting the safe will be $2. However, if the price per share of preferred stock in the preferred stock financing is $1, then the price per share used for converting the safe will be $1.
The fully-diluted capitalization can be calculated differently depending on the type of valuation cap on the safe. Traditionally, the fully-diluted capitalization is calculated excluding safes and convertible notes. If the valuation cap is a post-money valuation cap though, then the fully-diluted capitalization is calculated including them. The term post-money in post-money valuation cap refers to the fact that it functions as a cap on the valuation after (post) the safe financing (money) is taken into account.
Assume the valuation cap for a $1 million safe is $20 million and the fully-diluted capitalization of the company, excluding conversion of safes, is 10 million shares. Also, assume that this safe is the only investment the company has received.
If the valuation cap is a regular valuation cap, then the fully-diluted capitalization used for the safe conversion will be 10 million shares. If the valuation cap is a post-money valuation cap, then it will be 10,526,316 shares. This is because the $1 million is 5% of $20 million, and 5% of 10,526,316 is 526,316.
In this scenario, the price per share used for the conversion will be $2 in the case of a regular valuation cap, but $1.90 in the case of a post-money valuation cap (assuming the price per share of preferred stock in the preferred stock financing is higher).
By limiting the valuation used for conversion, valuation caps ensure that safes will convert into a minimum percentage of the company, as calculated prior to the preferred stock financing. For safes with regular valuation caps, this minimum will be lowered when the company issues additional safes. By contrast, for safes with post-money valuation caps, this minimum percentage remains the same no matter what other safes the company has issued.
Assume a company has never received any investment and has a fully-diluted capitalization of 10 million shares, excluding conversion of safes. If someone invests $1 million through a safe with a regular $20 million valuation cap, the safe will never convert into less than 500,000 shares. Immediately prior to the preferred stock financing, this would represent ~4.8% of the fully-diluted capitalization after the safe conversion (500,000 divided by 10,500,000).
Now suppose someone else invests another $1 million through an identical safe. That safe will also never convert into less than 500,000 shares. Immediately prior to the preferred stock financing, each safe would represent ~4.5 of the fully-diluted capitalization after the safe conversion (500,000 divided by 11,000,000). The first safe converts into a lower percentage as a result of the second safe (and vice versa).
If these safes had post-money valuation caps instead, each safe would be unaffected by the other. If the second safe were never issued, the first safe would convert into 526,316 shares (as calculated in the prior example). This would represent 5% of the fully-diluted capitalization after the safe conversion (526,316 divided by 10,526,316). If the second safe was issued, then each safe would instead convert into 555,556 shares, which would still represent 5% of the fully-diluted capitalization after the safe conversion (555,556 divided by 11,111,112).
Valuation caps are also referred to as conversion caps or target valuations.
The conversion price can also be set to have a fixed discount from the price per share of the preferred stock. This ensures that the safeholders will get a better deal than subsequent preferred stock purchasers.
If someone invests $1 million through a safe with a 10% discount, the safe will always convert into shares that are worth 90% of what someone would have to pay for the same number of shares in the preferred stock financing.
Some safes have both a valuation cap and a discount. When safes with both a valuation cap and discount convert, the more investor-favorable method is used - i.e. the method that results in the safe converting into more shares.
By default, if a safe has not already converted by the time the company is acquired, the investor has the choice of (1) receiving their investment back1 or (2) having the safe convert into common stock using the same valuation cap or discount as for a preferred stock conversion.
When investors have significant negotiating power, they may negotiate to have the safe specify an option to receive a multiple of their investment back (typically 2x). This has the effect of increasing the minimum acquisition price at which founders and employees will receive proceeds from an acquisition.