Today’s piece is a bit complex but if you want to fundraise, you need to know what SAFEs are and how dilution works. Because if you don’t, you may accidentally give away too much equity and be left with very little at the end. 

Since these concepts can be complicated, we reached out to Kristina Subbotina, founder of Lawlace, to explain how all these concepts work. If you prefer to watch, you can catch the Uncapped Notes episode here.

Dilution explained with pizza

Imagine you have a pizza pie. In the beginning, you and your co-founder(s) own 100% of this pizza (aka your company). 

Now let’s assume this pizza is worth $20. Most pizza shops simply need to sell as many pizzas as possible to grow their business. But in this example, you can’t duplicate your company 100 times. And even if you could, selling 100 pizzas would only give you $2,000 in revenue. 

Not bad for a pizza parlor. But you’re a startup. You’re looking for a much larger exit.

So your objective is to grow the value of your pizza. So it could be worth $20 now, but in 10 years, your pizza could be valued at $1 billion. So how do you grow the value of the pizza? You give away slices of the pizza to strategic people – investors, advisors, and key employees – who will massively help you.

Sure, you’ll lose ownership of some of the pizza. But these people can make sure the entire pie grows in valuation from $20 to $1M to $100M and hopefully to $1B. Even if you only own 15% of the pie, but it’s valued at $1B, your slice will be worth $150M. You won’t care that you don’t own the other 85% of the pizza because your small slice is so valuable on its own. 

But you need to be careful about giving away your pizza slices. As you can see, one small slice in the beginning can be worth millions of dollars down the line. So here’s the million dollar question: How much pizza should you expect to give away when you raise money? 

Kristina sees founders giving away 10-20% of pizza per fundraising stage. The gold standard is for the founders to still have the majority (more than 50% of the pizza) after their Series A round. It’s common to lose the majority by the time you raise your Series B. But as I mentioned earlier, this shouldn’t bother you if the value of the pie is high enough. 

What SAFEs are and why you should care

SAFE stands for “simple agreement for future equity.” SAFEs aren’t slices of pizza directly, but think of it like a ticket for a slice of pizza. You give these tickets to investors, which gives them the right to come back to you later to claim their slice (assuming the pizza is still alive and edible).

In non-pizza terms, a SAFE isn’t equity you sell to your investors, rather it’s the promise of equity in the future. Think of SAFEs almost like an IOU – you’re not issuing any equity yet… but once you have an equity financing round, an acquisition, or an IPO, that SAFE will get converted into equity. 

If your startup crashes and burns, the SAFEs are worthless.

There are two kinds of SAFEs: a pre-money SAFE and a post-money SAFE. When Y Combinator created the SAFE in 2013, it started as a pre-money safe. This is important - remember this.

These SAFEs were open-sourced documents that have become the standard for founders to use when raising money. Without a SAFE, founders would have had to pay lawyers to draft a new contract from scratch. This was expensive and complicated to manage. SAFEs made it much easier and more cost effective for founders to raise their earliest rounds.

But it had an unintended consequence. Founders wondered, “A priced equity round takes a lot of paperwork, negotiation, and legal fees which can easily cost us $20k. Why don’t I raise my entire round via pre-money SAFEs? I can just download it from the YC website and keep my costs low.”

So founders started raising $2-3M rounds via SAFEs. But once they’re ready to raise a priced equity round, founders aren't sure how much of the company they’ve actually sold. They sliced the pizza in all kinds of weird shapes and sizes and never kept track of who owns what. 

By the time all those people with pizza tickets come back to claim their slices, the founders may realize they had the smallest slice out of everyone… which can kill their incentive to grow the value of the pizza. 

Kristina worked with a client who's been doing business for a while and raised a bunch of money via pre-money SAFEs. Once this founder raised his equity round, he realized he only owned 35% of the company at the seed stage. 

No sophisticated investor would jump on board in that situation. Kristina is helping him with recapitalization to try and fix the problem, but we share these stories to prevent you from being in that situation in the first place.  

Eric Bahn from Hustle Fund offers this warning, “It is really easy to mess up these calculations when you have so many different kinds of pre-money valuations stacking on top of each other with capital that you raised prior to your Series A, or whenever your post-money raise takes place.”

Why founders are using post-money SAFEs instead

To rectify the unintended consequences, YC later introduced post-money SAFEs. They wanted founders to have clarity on how much of the company they’re selling. 

Here’s the magic equation: (investment) / (post money valuation)

• Example #1: The founder raises $500k on a $5M post-money valuation. $500k / $5M = 10%. This founder has sold 10% of the company.
  
  
• Example #2: The founder raises $1M on a $5M post-money valuation. $1M / $5M = 20%. The founder has sold 20% of the company. 

The math of what you’ve invested at the post-money valuation is simple and clear. This calculation is better for both the founders and investors because you know the exact percentage of pizza you’re giving away. 

What’s the takeaway here?

Your goal is to grow the value of your one pizza. Be strategic in who you give your pizza slices to because you want to own as much of your company as possible. 

Beware of using pre-money SAFEs because you likely won’t have an accurate calculation on how much pizza you’ve given away. Instead, use post-money SAFEs to have clarity… and sleep well at night knowing you still have enough pizza in the fridge to enjoy later.