Ajo Angels Weekly Pulse

That SAFE You Signed Might Tank Your Returns

Investment instruments are one of the most popular topics in my angel investing bootcamp, so I figured I'd give you a taste of that in this week's knowledge drop.

If you're getting into angel investing, you're going to hear the word SAFE a lot. Most people who explain it keep it pretty high level. They'll say it's a simple investment tool, it converts to equity down the road, and it's way less complicated than a priced round and all of that is true.

But there's something that almost never gets mentioned, and it can cut your returns by 30 to 50 percent. That's the question of if the SAFE is pre-money or post-money.

Most new angels don't understand enough about the difference and ramifications of both and that can be an expensive knowledge gap.

What's a SAFE

A SAFE (Simple Agreement for Future Equity) is a promise. You give a founder money now and get equity later; usually when the next funding round closes. There's no interest or repayment schedule, instead what you get is future equity based on the terms you agree on today.

Founders like them cause they can raise money without having to nail down a valuation while the company is still figuring itself out. Angels like them because the paperwork is fast and pretty straightforward. But simple paperwork doesn't mean low importance.

Pre vs. Post

When you see a SAFE with a $5M valuation cap, your first question SHOULD be: pre-money or post-money?

Post-money is the straightforward one. If you were to invest $5k into a $5M post-money SAFE, you'd own 0.1% of the company. If that company exits at $50M, you'll get $50k back; that's a 10x return. That's straightforward math that you can easily work out, and it doesn't change based on what the founder does after you invest.

Pre-money is different because your ownership percentage isn't locked in when you invest. Instead, it depends on how much total money the founder actually raises in that round, and you have zero control over and in most cases, visibility into that number. Most angels don't realize it's a problem until…it's a problem.

Say you put $5k into a $5M pre-money SAFE. If you project a $50M exit, that gets you about a 10x return right? Hold your horses cause here's the issue.

Scenario 1: If the founder raises $300k total. You'll convert at 0.094% so a $50M exit puts about $47k in your pocket. That's a 9.4x return.

Scenario 2: If the founder raises $2M total instead; on that same SAFE and the same $50M exit. You convert at 0.071% and now you're looking at $35.5k. That's only a 7.1x return.

This is the exact same deal with the same $50M exit; yet your return dropped by over 2x because the founder raised more than you thought they would, and to top it off, you won't find out which scenario you're in until conversion, that could be years after you invested.

This doesn't happen because founders aren't being dishonest. In fact it's actually a good thing that the founder was able to raise more money than expected. That people believe in the vision and that's always good. But the problem is that every extra dollar raised on a pre-money SAFE reduces your ownership %.

And this ladies and gents is how investors can end up with 30% to 50% less return than projected.

Why Post-Money Should be the Default Now

With post-money, your ownership/equity percentage locks in at the time you invest. Other investors coming in after you don't effect your number. The only thing that changes your percentage is a priced round, which you can see coming and plan for (and that's a different topic altogether).

Before You Sign

So what does this mean; it means one of the first questions you should ask if you're really interested in a deal is if it's pre-money or post-money?

If it's post-money, you're good. Run your due diligence then make your investment decision.

If it's set up as pre-money, if you really like the deal and don't want to pass; ask the founder if they're willing to do a post-money deal instead. And if they insist on pre-money, ask how much they're planning to raise in this round. Then project what your return looks like if they raise double that amount, because you don't know how much over their target they could raise, but doubling is a good estimate that will probably cover the most likely scenarios. This allows you to factor that into your investing decision.

You don't have to pass on every pre-money deal. But make sure you do your homework and understand the numbers and likely scenarios.

No deals this week

The idea of retirement is pretty new, it only became common in the early 1900s when life expectancy was much lower, so most people were not expected to live long after they stopped working? It was never designed for decades of living with decreased income.

Cheers,

Abdul

Hey Hey… I’m Abdul I’m the chairman of Ajo Angels and Shujaa Capital and I’m on a mission to introduce angel investing to 25,000 black folks over the next five years. I’m doing this with the goal of narrowing the racial wealth gap as well as trying to close the billion dollar funding gap for black founders.

This information is for educational purposes only and should not be construed as financial advice. Angel investing involves substantial risk, including the risk of total loss. Consult with a qualified financial advisor and attorney before making investment decisions.