Debt Sandwich 101

Hi, Buckle in: this week is a long one. I worked with Ari Newman, MD at Massive.vc to deep dive into the "debt sandwich" fundraising strategy. Also; 

📸 - Social Snapshot- Is your startup valuable?

📊 - ESOPs vs Cash

🎙️ - Episode 51: Actor turned VC launches Venture Fund for Alcohol

🆓 - Startup resource- Term Sheet Negotiation Playbook Welcome to issue #91! 

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Social Snapshot

Thoughts on growing your business by Alex Hormozi on X.  Also: 📄 Paul Graham's 1-pager on starting a startup, shared by Ben Lang on X

🆕 Another POV on starting a startup from Alex Friedman on LinkedIn

Episode 56: Are Vices in VC Vogue?

The Fundraising Demystified podcast is back! I sit down with Noah Friedman, an actor turned VC who launched a venture fund for alcohol.

Learn more about how he is changing the vices sector in the latest episode.

Watch Now

Data Corner

Equity vs Cash

Startup equity isn’t cash, but founders often present it that way when talking about ESOPs. Instead of listing equity as a dollar amount, it’s more accurate to offer shares as a percentage, as early-stage equity may hold little value.

Competing with Big Tech’s cash-equivalent equity is tough, so founders should focus on other benefits like mission and growth opportunities to attract talent.

Candidates should always ask for the company’s total outstanding shares to understand their actual ownership percentage when offered stock options.

Craving a debt sandwich?

The practice of “stacking SAFEs” has now become commonplace for early-stage startups. SAFEs are the preferred method of raising money at the pre-seed and seed stage. There is one big elephant in the room no one likes to talk about and that is that stacking SAFEs can cost you an additional 20% of your company if you are not careful. SAFEs can be great tools for raising capital but there are pros and cons to delaying raising a priced round for too long.

This article explores this topic in-depth and should help founders critically about the most popular early-stage financing instrument of 2024. 

 It should come as no surprise to investors and founders active in early-stage investing that SAFE rounds have become a standard. It is actually quite rare to see priced rounds at pre-seed and seed stages these days. The chart below, shared in a previous newsletter on SAFEs tells the story well. 

Let's dive in, and discuss a few big questions up front. 

What is a SAFE?  

The Simple Agreement for Future Equity) is an investment subscription document published by Y Combinator several years ago. The instrument has changed and evolved over time but it remains a very simple structure that essentially says “If this company raises an equity round, your investment today will convert into Preferred shares (vs common)”. It has optional features such as a conversion cap (the highest valuation the investor will pay when the shares convert) and a discount option (the investor pays less than 100% per share when converting) in order to incentivize investors to engage. A SAFE is not a debt instrument like a Convertible Note (CN) and would be subordinate to the holder of a CN in the case of liquidation of assets. 

Why have they taken over the industry?

There are many reasons.  Some of them (not in order) include

1) YC published this, shared it with the world, and uses it for thousands of companies. They set a “founder-friendly” standard in Silicon Valley 

2) Most of the friction associated with priced rounds is gone. A startup can download a SAFE template for free here, send it to an investor, and receive funds. Fast, cheap, and easy, and very little legal or operational oversight. 

3) There are few qualifying provisions so money can be raised progressively - either quickly or slowly.

4) The company does not need a “lead investor” to agree on a company valuation, join the board, lead the deal term negotiations, incur expenses, etc.

5) SAFEs are favorable over CNs (which also have some of the same benefits of #4) because there is no interest payment, no redemption option and is not considered debt to the company or other interested parties. This is even more company and founder-friendly than CNs.

The double-edged sword of “founder friendly” - YC had a lot of good reasons to create and publish the SAFE as an alternative to convertible notes. When you are onboarding 100 tiny companies into a cohort, low-friction goes a long way. Fewer terms means less to negotiate or mark up, easier to adhere to a standard and easier to track, model and manage conversion down the road. 

So where are the problems?

Sometimes the formula of “cheap, easy and founder friendly” can become toxic for a company and detrimental for investors. It is worth noting  here that this instrument makes a ton of sense for YC and high volume super early stage investors. This has made it super easy for YC companies (or anyone using SAFEs) to raise money without doing much on the operational hygiene side. When you are running an at-scale arbitrage model, you want your companies to raise as much as they can, go fast and let the Seed or Series A investors clean it up later. Slowing down the business or burning cash on lawyers is seen as a drag, right? The dark side of SAFEs start to show up when the dust settles from the formation days and the business settles into the long hard slog of turning an idea into a company. When there is tons of investor demand and not a lot of price sensitivity, many of these challenges become moot until they whiplash the company later on. 

1. No Lead - No Problem? If the SAFE round had no lead investor, it's very possible the company did not form a board that included outside interested parties. Is there a sufficient operating agreement? Does the company have insurance, protections and governance in place? This is on the investors to diligence for themselves but many just “follow each other off the cliff”. Great for experienced and professional founders who know how to run a venture-backed business. Not so great for 1st time founders who are learning on the job as its very easy to miss things or make mistakes that become expensive later. We are big believers that a little extra structure and help being smart about the cap table, option pool, and future round formation goes a long way.
2. Investors should have some rights - Investors are not granted information rights, follow on rights, voting rights, etc. Founders can use SAFEs to raise $500k or $5M without needing to get approval from anyone outside the other founders if the Board is made up of two co-founders, or if there is no board at all. The company’s future ability to raise equity can be materially impacted here. The company can keep raising while burning, just to stay alive but never improving the runway or resource level to achieve its goals. Oftentimes VCs who will invest on a SAFE will request a side letter granting information and follow-on rights. Founders who do not disclose these additional terms to all investors run the risk of losing trust, and yet granting follow-on rights across the board also means the next round can be materially consumed by insiders.
3. Stack em up! - Some Founders become hyper-focused on minimizing dilution, and begin to “stack” the SAFEs - this is the process of increasing the conversion cap each time they raise another tranche of capital. We believe that a valuation cap does create a signal to the market around expectations. When that number gets too high it also tends to drive the company to keep raising on SAFEs longer and longer, which means the conversion overhang becomes challenging and the only path is the “big up round”. Which needs a lead investor who has so much conviction they are willing to do all of the historical cleanup work, write a handsome check and agree to a post-money valuation that achieves ownership targets, dilution resistance and preserves founder equity sufficiently. This can become a challenging puzzle and throw off company and investor alignment.  

All of the theoretical downside risks aside, let's look at the numbers and take a real-world example of recent financing (company name redacted), and run the analysis in both the “debt sandwich” strategy that Ari Newman of Massive discusses in his post series, and with the stacked SAFEs approach that has become commonplace.

• Total Raised: $4.2M
• SAFE 1: $1M @ $6M Cap
• Seed-1: $1.2M @ $10M post-money valuation
• Oh, and the option pool:
• Enter SAFE 2:
• Seed-2:
• The grand total:
• Final dilution across three financing cycles:

Basically, the original founders and early investors are diluted by about half, but that’s what you get when you raise $8M to grow the company!

Hope that's all clear, but feel free to drop me, or Ari a line for more info. Plus, subscribe now for next week's episode of the podcast where Ari and I talk more about this strategy.

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