SAFEs (Simple Agreements for Future Equity), and other regional variants of the SAFE, have surged in popularity in recent years. These financial tools streamline the fundraising process by skipping over a lot of the complexity of a priced round, in the terms and conditions, thereby accelerating capital acquisition for founders.
A pivotal feature of SAFEs is their ability to incentivise early investors through mechanisms like valuation caps or discounts. These features determine the conversion rate of the SAFE into equity upon a subsequent priced round, and are designed to reward early investors for the additional risk they have taken by committing earlier.
Understanding when to deploy a valuation cap versus a discount is crucial for both entrepreneurs and their investors. Each mechanism has its strategic implications. You can read more about both terms, the logic behind them, and other aspects of using convertible instruments like SAFEs, in our deep-dive article: “SAFE Caps and Discounts: Setting the right terms for your round”
In this article, we explore the role of the cap, how it works in practice, and a recommend approach to setting the right cap if you choose to pursue financing on a SAFE. For perspective on when and how to use a discount instead, we have a similar article available here.
The purpose of a SAFE cap
A cap sets an upper limit on the valuation at which the SAFE converts into equity.
For example, if you were to take a Pre-Seed investment via a SAFE with an $8M (post-money) cap, and then you went on to raise a Seed round at $12M pre, equity would be issued to SAFE holders based on the $8M cap.
When to use a cap, rather than a discount
Valuation caps imply that both sides have a rough understanding of a number of factors, including when a priced round is likely to happen, and approximately at what value it is likely to take place. Setting a cap is effectively planting a flag in the future; a target price for that point in time.
This applies best to startups on a more predictable startup growth path, such as SaaS or consumer apps, where a cap can be determined more easily.
The typical approach to setting SAFE caps
The cap should balance between being attractive to investors and reasonable for the company’s founders, reflecting the startup’s potential growth without being overly dilutive.
When determining an appropriate cap for a SAFE financing round, both investors and founders typically consider the following factors:
- Current Valuation Estimates: While a SAFE is often used before a formal valuation, founders and investors might still have rough estimates based on market comparables, revenue projections, or recent fundraising activities. This helps establish a realistic range for the cap.
- Stage of the Startup: The startup’s maturity and progress, including milestones achieved (e.g., product development, customer traction, revenue growth), play a crucial role. Earlier-stage startups often have lower caps due to higher risk, while more mature startups with proven traction might set higher caps.
- Market Comparables: Looking at similar companies in the same industry and their valuations can provide a benchmark. This helps in setting a cap that aligns with industry norms, ensuring that it is attractive to investors while still reflecting the startup’s potential.
- Negotiation and Investor Appetite: The cap is often a point of negotiation between founders and investors. Founders might push for a higher cap to minimize dilution, while investors might advocate for a lower cap to maximize their upside. The final cap is usually a compromise that reflects both parties’ expectations.
- Risk and Growth Potential: The perceived risk associated with the startup and its potential for significant growth influence the cap. Higher growth potential might justify a higher cap, while higher risk might necessitate a lower cap to attract investors.
Our recommended approach
Given what a cap sets out to achieve, an appropriate solution is to use the top of your current valuation range as the cap. This way, you’re maintaining a coherent story with investors.
While investors may be skeptical valuations predicated on assumptions about the future at such an early stage, it’s an effective way to use data about the company and its projected future to justify your cap. By the time you get to that priced round, you should have proven much of your initial pitch by hitting those milestones and building traction.
In the example below, we’ve used the valuation for a startup raising a $1.5M Pre-Seed SAFE round to determine the valuation cap that will be offered to investors, via the high bound of the valuation range provided by our methodology — though any similar approach which outputs a high bound would be appropriate.
| $1.5M Pre-Seed SAFE | Cap (High bound of weighted average) |
|---|
| Scorecard | Checklist | VC Method | DCF with LTG | DCF with Multiple |
|---|---|---|---|---|
| 30% | 30% | 16% | 12% | 12% |
| $6.36M | $5.75M | $6.26M | $4.93M | $21.66M |
| Low Bound | $6.47M |
| Weighted Average | $7.83M |
| High Bound (Cap) | $9.18M |
| Dilution | 16.34% |
To understand the low and high bound, we look at the variance between the different methods, and the 30th percentile and the 70th percentile on that curve.