Two-part seminar series. Each part is 50 mins, taught back-to-back.
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I. Socially engineer your preseed to get the best possible terms – MFN / uncapped
II. Financial & legal nuances of SAFEs – valuation, compliance, minimizing costs
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Free primer notes below
Part I: Pre-seed Fundraising is Poker, not Chess
“If you sit in on a poker game and you don’t see a sucker at the table, get up. Because you’re the sucker.” – attributed to many, but originally from John Spooner
“The reality – and its a reality that clever players try to obscure from the naive – is that business relationships (including startup ecosystems) are full of both positive and zero-sum games, many of which are unavoidably linked.” – Silicon Hills lawyer
- Pick the right table for your pre-seed
- Winning a poker game is more social engineering than math / formal analysis
- We will discuss a useful example / analogy from an actual poker pro
Get the best possible terms (MFN or at least uncapped) by sitting at the right table and employing three strategies. The ideal result is an MFN SAFE (or at least uncapped)
- Good-will – ask for a favor (social impact)
- Scarcity – do them a favor (insider deal)
- Clean-cap – do us both a favor (don’t cause problem for the future)
Schematic case using the above strategies – see also Google (1998)
Let’s say that after achieving one or two milestones in the next 1–3 years, you think you can raise seed or Series A at a substantial valuation, perhaps a few or several million at @$25M pre-money. You may even know from whom you intend to raise. You could use some pre-seed now, however. At this point, to raise a low valuation (often as low as $2–3m) as a concession for being so early. But there is a way to think about your positioning and value proposition, using the above strategies. They were actually germane to the pre-seed funding of Google while the two founders were still in grad school. We will go over what happened with Google in 1998, including the two investor checks that, famously, sat in a drawer for a while because the company they were made out to, Google, Inc., did not yet exist.
Assume you know a few VCs who operate institutional funds. If a VC likes a deal but the deal is not right for her fund, she might invest her own money. No matter how good a relationship you have with her, if you asked her for $1M in seed, she is likely would to negotiate with you, because $1M is serious money, even for her. And because you don’t have very much going for you yet, you would get crushed on the valuation. However, if you asked for a relatively small amount (for her), say $25K, she might be willing to give you good faith terms. What I mean by that, is that if you are below a certain threshold, she might be willing to do you a favor- not give the money to you for free, but not bother to negotiate terms, either. The formalization of such good faith terms is formalized as MFN (“most favored nation”).
Which brings us to Google in 1998. When the Sergey and Larry had dinner with professors Cheriton and Bechtolsheim, the latter each handed over $100K checks at the end of the evening, famously, before the company was even incorporated (so the checks sat in a drawer for awhile). We can think of that $200K as Google’s pre-seed. We can think of the money that was raised few weeks or months later as the seed. Anecdotally, David and Andy did not define any terms at pre-seed. In other words they were willing in good faith to assume that Sergey and Larry would give them fair and standard conventional terms. Likely the seed was was done as a convertible note at a 20% discount to the Series A and David and Andy got the same. I have not asked any of these people what the terms actually were, and they likely don’t remember. Also, to be honest, it’s not the sort of thing you want to expend cycles on when you are fortunate enough to spend time with such people 🙂
A 20% discount is not MFN. What was MFN was the relationship of the $200K pre-seed to the $1M seed. In other words, the professors got MFN with respect to the later $1M seed.** Had they chosen to, David and Andy could have negotiated with Larry and Sergey– since we are the first investors, give us a better deal. The important point is that they didn’t care to. For a very early-stage startup, this is probably the only way not to get crushed on terms– to operate below the “negotiating threshold”. This is what I term the good-will driven strategy.
Perhaps you don’t know any fund managers, but you likely know other people who can make such an investment: doctors, real estate investors, etc., and if they are not in your industry, you can give such people the opportunity to learn about something new by investing in something new. This is part of what I term the scarcity-driven strategy. Another good source of capital of course are already successful people in the industry you are trying to change. I stated in the first paragraph that this type of investment is about their faith in you. So it might now be someone who is especially well off or “smart money” in your industry, it might be someone you have know since high school, who has seen you operate and knows your abilities, intelligence, and character, who can give you $10K. Multiply $10K a few times and you will start to see real money. Thus you can use both a mix of good-will and scarcity in your social engineering, though usually not with the same investor.
If this approach doesn’t sound promising to you because you don’t know many people like the above, then you probably need to rethink your company roadmap. Building a startup is mostly about building goodwill and inspiring confidence, particularly early on when you have no resources. If you have been locked in your lab for the past three years doing nothing but engineering or sciencing (I have seen many example of this), you are going to have a hard time getting investors, customers, partners, co-founders, employees, because they are not going to care about how great your invention is if they don’t care about you. If all you care about is the technology, then perhaps this approach is fine, but if you are building a company, then probably you care about actual people using and buying your product, not just the technology itself. This misapprehension is what I call the formalistic approach to fundraising. Some people think that they can just go and find a VC in their industry and raise money from them using formalistic advice on pitch decks, TAMs, industry analyses, etc., when in reality raising money from a VC is not that different from asking your best buddy from HS for $10K.
There are some founders in the right industries with the right credentials (PhD in computer vision from MIT doing an ML startup) that can raise money the formalistic way (or at least get a lot of intro meetings). More often than not, though, such founders fail when it comes time to actually close the deal.
**This could be described as an MFN with amendment (a nuance you can look up) rather than MFN, but this is just a matter of semantics, because it was a handshake deal. In other words, the professors weren’t so specific as to say “give us the same terms as your priced round, but update our terms to an intermediate financing, if it happens” they just handed them the checks and didn’t worry about the details, so depending on how interpret that, that is MFN or MFN with amendment.
The legal instrument to use for this strategy is the MFN SAFE. People generally refer to the most founder friendly SAFEs as being “uncapped”, but to be rigorous, they should be referring to MFN. MFN means no cap and no discount, as opposed to just no cap. It discount term is easier to understand and has more transparent consequences (unless some rather unusual wording exists in your document, which is certainly possible) so I would say that uncapped is almost as good as MFN. Note that founders tend to think that a high cap is almost as good as no cap, but it can have significant, non-obvious consequences, see: Why Startups shouldn’t use YC’s Post-Money SAFE.
Below, we will go into some detail about the differences between the terms post-money and pre-money (definitionally). Note that this is not the same as the difference between the post-money SAFE (2018) and pre-money SAFE (2013) because those are actual document that have differences beyond pinning valuation on a post-money vs pre-money definition. Further, you don’t have to understand post-money vs pre-money at all if you use an MFN or uncapped SAFE, because then there is no valuation calculation – yet another reason to go MFN.
colloquially referred to as the post-money SAFE and the pre-money SAFE. For a contrary take, see: Uncapped SAFEs: when to use them, no cap. I actually don’t think his logic is inconsistent with mine, we are just walking about different poker tables.
YC & $350K MFN
In 2022, YC changed its seed investment from $125K to $475K (the extra $350K being as an MFN SAFE). The value of YC has been seriously diluted over the past decade, and I was generally hesitant to work with or invest in a YC company for two reasons. (1) startups often go to YC for signaling value alone. So while the average YC startup is better than the average startup, unmodified (which is not saying much), the best startups tended to not want YC’s onerous investment terms. The startups that did so often because they had no better option, because they had so little experience and that even a diluted YC experience was seen as valuable, and/or because the founders were status conscious. In other words, they valued YC as a brand like Harvard or McKinsey, and not so much intrinsically motivated by their project. I think the best founders are the types that can get into Harvard but don’t care much about it or don’t even go. Another problem is that the valuations coming out of YC demo day are generally too high.
I believe that $475K is fundamentally different than $125K in terms of runway, so I can see much more of a reason to go to YC now based on fundamentals. I hope other accelerators will follow suit.
Part II. Technical Details of the SAFE
Pre-Money vs Post-Money & why the Standard Post-Money SAFE is confusing
The default SAFE document used throughout the world today is the YC 2018 v1.1. SAFE, referred to as the Post-Money SAFE. At a basic level, the concept of pre-money vs post-money is financing round is simple. The value given to the company is pre-money, then you add in the money invested, to arrive at the post-money valuation:
PRE-MONEY + MONEY == POST-MONEY
in other words
COMPANY VALUE + $ INVESTED == POST-MONEY VALUATION
The widespread confusion caused by the meaning of “post-money” in the SAFE has been created by the development of rolling rounds, which didn’t become the norm till several years ago. Before that time, companies generally raised, and attorneys insisted on, discrete financing rounds, in other words, a precise amount to be raised from enumerated investors, all closed (executed and wired) on the same date (or at most a few dates). This is what was meant by a financing “round”. With the development of YC SAFEs and DIY, founders started raising money in a much more open-ended fashion. They often found an investor or two to agree to terms, started raising on that basis, and kept raising on SAFEs it if they felt they could and should, sometimes kept doing this for months or years. Sometimes the founders amend the terms as time goes on (typically by raising the cap). This low-friction but less disciplined way of raising money, and it has become quite common under DIY.
This following is what an “anachronistic” discrete round looks like. Let’s say you want to raise $100K. Since that number is fixed, the formula is simple. As you can see below, a $3M post-money valuation and a $2.9M pre-money valuation are exactly the same, because the difference is $100K. Thus all the variables are known, and these valuations essentially would be set in stone until Series A.
(a) $2.9M + $0.1M == $3.0M
Now imagine the round rolls to $2M. Then post-money vs pre–money makes a huge difference. If you say $3M post-money, then you get
(b) $1.0M + $2.0M == $3.0M
But if you say $2.9M pre-money, then you get:
(c) $2.9M + $2.0M == $4.9M
With the original 2013 pre-money SAFE, the investors were caught by surprise and dismayed by the unexpected $4.9M number coming out of the rolling round. So YC switched to post-money, and now founders are being caught by surprise and being dismayed by the $1.0M number.
The original intent of the term post-money would be captured by making the following changes to the valuation language, even for rolling rounds, The changes (bold) pin the post-money valuation to a discrete contemporaneous round (e.g., money being raising this week, not uncertain amount to be raised TBD for months and years). Note that this language is not legally precise:
Post-Money SAFE: the definition of post-money is changed from including all “converting securities” to including all converting securities that are part of the current round or an earlier round.
By the same reasoning, attorneys Ancer and Adler (SIlicon Hills and PNW) have amended the post-money SAFE in almost exactly the same way (Box link below).
The pre-money SAFE can be fixed in a similar way:
Pre-Money SAFE: the definition of post-money is changed from excluding all “converting securities” to excluding all converting securities before the current round.
SEC & IRS Compliance
To simplify, tiny startups need to abide by the same rules as giant hedge funds and companies raising $500M for a Series A. This is huge pain and expense at the early stage, and can cost you several or even tens of thousands of dollars. This is in part because each state has different rules, and while they are generally similar, sometimes they are not. Until several years ago (again, before DIY), lawyers would generally insist in these being done. Most SEC and state rules state that they must be done within 15 days of the first sale. Even before DIY, it was common for these to be done a little late, because it was difficult to round up all the paperwork and because there was little or no consequence of being late. So, if it’s OK to be a little late, is it OK to be a lot late (delayed compliance)? It’s ultimately for you to decide, although your service professionals will have their own takes.
These are the common early events that require such filing:
- Founder stock grant
- Stock option plan creation
- Any investment (SAFEs and notes)
- Any other stock grant that is not part of the stock option plan
As you might imagine, #4 is easier with a discrete round on a single day than for a rolling round, where you might have to do dozens of filing for each 15 days window of SAFE issuances. It was and is common to try to wait for more than two of these events to happen so the filings could be done at once, even if they were more than 15 days apart. By this logic, why not wait until many of these things occur and do the filing at all at once. With the advent of Clerky and DIY, this effectively is what is happening. Some founders are not even aware of such requirements, so when they get to Series A, the lawyer identifies this issue and addresses. And of course, there is the logic that if the company fails before Series A, no harm no foul, but that is not quite true, as closing the company does not extinguish this obligation.
SAFEs and convertible notes are generally regarded as liabilities for 409a valuation purposes, but check with your provider. This means they will not substantially raise your stock option strike price.
Note that the National Venture Capital Association has issued model documents for decades, but there was not much guidance for founders to use them effectively.