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SAFEs aren’t so safe after all…
I’ve longed joked that dilution is a thief in the night.
Take it away, Rhianna
If you aren’t vigilant, dilution will pilfer piece after piece of your company. And it comes in many forms, some more “known” than others.
As a reminder, dilution strikes whenever new (more) shares are issued (created).
Here are some common scenarios:
When the Firm Completes a Fund Raise: This is the most well known scenario. When a company does a fund raise they can raise primary dollars, secondary dollars, or a combination of both.
When a firm raises primary dollars they create new shares out of thin air. Doing so increases the denominator that existing shareholders measure their holdings against.
IPO: An IPO is similar to a private fund raise in the sense that it can have both primary and secondary components. The primary offering creates new shares and dilutes existing shareholders on the cap table.
Secondary dollars are just existing shareholders selling to new shareholders. None of this money goes to the company to fund operations, only to the employee to buy something nice (or pay off their tax bills from exercising said shares, lol)
When Convertible Warrants or Bonds are Exercised: These are usually issued to angel investors as a convertible note or founder friendly banks or private debt providers (like a Silicon Valley Bank, MUFG, or Hercules Capital). For angel investors, this type of security is often issued before a valuation is set in stone. When debt is converted to equity, this makes the number of outstanding shares go up, which dilutes the existing holders.
SAFEs fall into this category. Hold that thought; we’ll dig in below.
When Employees Exercise Options: When an employee exercises their option to buy shares in a company this increases the total number of shares outstanding. Before the employee just had the “option” to buy shares. Now that they’ve actually cut a check to own them, more shares are created and the pie gets bigger. If they leave before their vesting period is up, the options return back to the pool and can be reused, so no dilution occurs.
Public Service Announcement: It’s not necessarily a bad thing if any of these events occur in conjunction with an increased valuation. Your slice of the pie gets smaller, but the overall pie is worth more.
However, not all dilution is created equal.
Early money is the most expensive money you’ll take. It’s when the most dilution typically occurs. And it’s increasingly common for that dilution to occur in the form of SAFEs.
The SAFE, or Simple Agreement for Future Equity, was invented by Y Combinator in 2013. It allows initial investors to fund a good business concept without dithering over valuation.
Spoiler alert: it’s really hard to come up with a price per share for something that’s still an idea on a piece of paper.
A SAFE is neither debt nor equity. And it doesn’t accrue interest or have a maturity (read: expiration) date. But it does convert into equity when / if the company raises a priced round or gets acquired.
So the whole premise is, “Hey, this is a really quick way to get cash into the business. Let's not play this hot potato game of ‘what am I worth?’ We have no revenue yet. What do you think we're worth? Let's come up with a way to basically kick the can down the road on what the price will be.”
On the surface, SAFEs are, as their name sake states, simple. But since financial analysts are involved, there are many ways to crank the volume up to 12 and create a monster. It’s also why we can’t have nice things.
Making the Rounds
I checked in with Peter Walker, head of insights at Carta, to get the latest on dilution by round:
“The first priced round for most companies is still a priced seed round, although a lot of it is happening on SAFEs as well.
In a priced seed and a priced Series A, you're still selling 20% or so of the business. That median, that market, hasn't really changed much over the last five years. It's usually around 20%.”
So that’s where we start. Then we work our way backwards to the pre-seed.
Now, this is the messy part.
“This is the part that is kind of all over the place. We typically see that companies are now raising their first funding on SAFEs or convertible notes, primarily SAFEs. And by doing so, it delays the actual dilution because that SAFE doesn't convert until you raise a price round.
However, that does not mean that you DIDN’T sell anything, it just means that that dilution is delayed, and that can really trip founders up in their mental model.”
Let’s use a simple example. You’re raising $1 million as a pre-seed round, and you probably do it on an $8 to $10 million valuation cap. Therefore, you’ve sold 10% to 12% of the business, it just hasn’t happened yet.
OK, cool. A bit cloudy with a chance of meatballs but let’s move on.
Flash forward and you’ve done four of these. All at different valuation caps.
As more and more of the early funding happens on SAFEs, it becomes more opaque as to what the actual dilution to the founding team is as they proceed through the fundraising lifecycle. Dilution is getting delayed, not denied, and there is a lot more than you’d think in that backlog. And when you don’t know how much you’ve given away, you can make poor capital allocation decisions.
Checking the Bar Tab
If we do some quick math, it’s typical for a company to give away 10% on pre-seed SAFEs. To do that three more times, and then STILL follow the standard Seed, Series A, etc. path, it will look gruesome.
You may give up an extra 20% or more of your company when it’s all said and done.
By Carta’s estimate, assuming you don’t stack SAFEs like Lego blocks:
Pre Seed: 10% dilution
Seed: 20% dilution
Series A: 20% dilution
So after your Series A, half the company is in the hands of investors.
Wait!
Actually MORE than half - you need to factor in the employee option pool.
It’s typically 8% to 10% pre seed, and by the time you get through Series A it reaches 12% to 13%. Like I said, that thief sneaks up.
So if you look at the founding team post series A, the median they’re left holding is between 38% and 39% total ownership.
For those keeping score at home, it’s pretty wild that you may own less than half your company before you ever raise your Series B.
In this all too common example, more than 60% of the company is no longer in the hands of the founders after Series A. And if there’s two equal cofounders, each has less than a 20% stake in their own company by now.
Hence, it drives home the point of why raising multiple SAFEs, and losing track of the ball, is so dangerous.
Don’t hate the player, hate the game
It’s hard to be mad at a legal construct. It’s kinda like getting mad at your toaster because it burnt your bread. OK, well maybe you shouldn’t have turned the nob to nine and left the room.
The real issue is founders beating something to death that was only meant to serve as a stop gap. Just because you cover your eyes and ears, doesn’t mean it didn’t happen.
In doing so you’re also giving investors terms, specifically anti-dilution, that you would never give them in a priced round. It’s very founder aligned the first time you do it, but by the fourth or fifth time, you are just not serious people.
Per Peter Walker:
“The problem is when you continue to just kick that valuation can down the road two or three or four, heck man, we've seen founders on Carta do 10 different SAFEs at different valuation caps before…
Yes, 10 different caps in a single company. You're just not being serious. You need to convert that to an actual price round, and I understand it costs more in legal fees. Lawyers are sometimes good, pay the money.”
After 3 SAFEs, you are not serious people.
While SAFEs are meant to come early, they are showing up too often.
Building a company is a serious endeavor. Don’t treat your cap table any different.
This Week’s Benchmarks
The overall median still hovers below 5.0x, which is lower than we’ve historically seen. GTM (MarTech & SalesTech) is getting slammed in particular, with the median falling to just 3.3x forward revenues.
The top ten median trades above 18x, more than 3x the overall cohort.
Top 10 Medians:
EV / NTM Revenue = 18.3x (UP 0.8x w/w)
Revenue Growth Rate = 27% (flat w/w)
CAC Payback = 20 months (DOWN 4 months w/w)
Rule of 40 = 49% (flat w/w)
Revenue per Employee = $575k (UP $112K w/w)
Overall Median:
EV / NTM Revenue = 4.7x (DOWN 0.1x w/w)
Revenue Growth Rate = 13% (flat w/w)
CAC Payback = 36 months (flat w/w)
Rule of 40 = 38% (flat w/w)
Revenue per Employee = $416k (UP $7K w/w)
Figures for each index are measured at the Median
Median and Top 10 Median are measured across the entire data set, where n = 144
Population Sizes:
Security & Identity = 17
Data Infrastructure & Dev Tools = 13
Cloud Platforms & Infra = 15
Horizontal SaaS & Back office = 19
GTM (MarTech & SalesTech) = 19
Marketplaces & Consumer Platforms = 18
FinTech & Payments = 25
Vertical SaaS = 18
Revenue Multiples
Revenue multiples are a shortcut to compare valuations across the technology landscape, where companies may not yet be profitable. The most standard timeframe for revenue multiple comparison is on a “Next Twelve Months” (NTM Revenue) basis.
NTM is a generous cut, as it gives a company “credit” for a full “rolling” future year. It also puts all companies on equal footing, regardless of their fiscal year end and quarterly seasonality.
However, not all technology sectors or monetization strategies receive the same “credit” on their forward revenue, which operators should be aware of when they create comp sets for their own companies. That is why I break them out as separate “indexes”.
Reasons may include:
Recurring mix of revenue
Stickiness of revenue
Average contract size
Cost of revenue delivery
Criticality of solution
Total Addressable Market potential
From a macro perspective, multiples trend higher in low interest environments, and vice versa.
Multiples shown are calculated by taking the Enterprise Value / NTM revenue.
Enterprise Value is calculated as: Market Capitalization + Total Debt - Cash
Market Cap fluctuates with share price day to day, while Total Debt and Cash are taken from the most recent quarterly financial statements available. That’s why we share this report each week - to keep up with changes in the stock market, and to update for quarterly earnings reports when they drop.
Historically, a 10x NTM Revenue multiple has been viewed as a “premium” valuation reserved for the best of the best companies.
Efficiency
Companies that can do more with less tend to earn higher valuations.
Three of the most common and consistently publicly available metrics to measure efficiency include:
CAC Payback Period: How many months does it take to recoup the cost of acquiring a customer?
CAC Payback Period is measured as Sales and Marketing costs divided by Revenue Additions, and adjusted by Gross Margin.
Here’s how I do it:
Sales and Marketing costs are measured on a TTM basis, but lagged by one quarter (so you skip a quarter, then sum the trailing four quarters of costs). This timeframe smooths for seasonality and recognizes the lead time required to generate pipeline.
Revenue is measured as the year-on-year change in the most recent quarter’s sales (so for Q2 of 2024 you’d subtract out Q2 of 2023’s revenue to get the increase), and then multiplied by four to arrive at an annualized revenue increase (e.g., ARR Additions).
Gross margin is taken as a % from the most recent quarter (e.g., 82%) to represent the current cost to serve a customer
Revenue per Employee: On a per head basis, how much in sales does the company generate each year? The rule of thumb is public companies should be doing north of $450k per employee at scale. This is simple division. And I believe it cuts through all the noise - there’s nowhere to hide.
Revenue per Employee is calculated as: (TTM Revenue / Total Current Employees)
Rule of 40: How does a company balance topline growth with bottom line efficiency? It’s the sum of the company’s revenue growth rate and EBITDA Margin. Netting the two should get you above 40 to pass the test.
Rule of 40 is calculated as: TTM Revenue Growth % + TTM Adjusted EBITDA Margin %
A few other notes on efficiency metrics:
Net Dollar Retention is another great measure of efficiency, but many companies have stopped quoting it as an exact number, choosing instead to disclose if it’s above or below a threshold once a year. It’s also uncommon for some types of companies, like marketplaces, to report it at all.
Most public companies don’t report net new ARR, and not all revenue is “recurring”, so I’m doing my best to approximate using changes in reported GAAP revenue. I admit this is a “stricter” view, as it is measuring change in net revenue.
OPEX
Decreasing your OPEX relative to revenue demonstrates Operating Leverage, and leaves more dollars to drop to the bottom line, as companies strive to achieve +25% profitability at scale.
The most common buckets companies put their operating costs into are:
Cost of Goods Sold: Customer Support employees, infrastructure to host your business in the cloud, API tolls, and banking fees if you are a FinTech.
Sales & Marketing: Sales and Marketing employees, advertising spend, demand gen spend, events, conferences, tools.
Research & Development: Product and Engineering employees, development expenses, tools.
General & Administrative: Finance, HR, and IT employees… and everything else. Or as I like to call myself “Strategic Backoffice Overhead.”
All of these are taken on a Gaap basis and therefore INCLUDE stock based comp, a non cash expense.
Please check out our data partner, Koyfin. It’s dope.
Wishing you a clean ass cap table,
CJ
