Company capitalization: The most overlooked definition in your SAFE 

Editor’s note: The opinions expressed in this commentary are the author’s alone. Gabriel Riekhof is an attorney at Husch Blackwell, a leading law firm that provides unparalleled service and industry-specific solutions to clients nationwide.

Introduced by Y Combinator in 2013 as an alternative to traditional convertible notes, a “Simple Agreement for Future Equity” or “SAFE” aims to streamline the investment process for early-stage startups by providing a simpler instrument for selling equity.

Although the document has the word “simple” in the title, founders can rarely answer the most fundamental question posed by a SAFE: How many shares will the SAFE convert into?

This article aims to help you answer that question. 

The Mechanics of a SAFE

Typically, there are two distinct forms of SAFE that Y Combinator publishes for a founder to choose from to incentivize an investor to purchase a SAFE: (i) the Discount SAFE and (ii) the Valuation Cap SAFE. This article discusses the Valuation Cap SAFE only.

In “simple” terms, a Valuation Cap SAFE sets an agreed upon maximum future valuation of the company issuing the SAFE that “caps” the per share “conversion price” used to convert the SAFE into preferred stock. All else equal, a lower valuation cap results in a lower per share conversion price. A lower conversion price means the investor’s original investment amount will purchase more shares. The more shares an investor receives, the greater the investor’s equity in the company, and therefore less equity remains with the founders.

At the risk of losing your interest this early in the article, I’m going to take a risk and give you the formula that governs the operation of a Valuation Cap SAFE. It does not have to make sense, yet. Just use it as a reference while you read the next paragraphs and examples: 

S = P / CP 

S = Shares of preferred stock that the SAFE will convert into. 

P = Purchase Price of the SAFE (the investment amount). 

CP = Conversion Price = X / Y. 

X = Valuation Cap.

Y = Company Capitalization. 

Example 1: Using the Valuation Cap 

If an investor purchased a SAFE for $50,000 (P) with a $1,000,000 Valuation Cap (X), and the Company has a Company Capitalization of 1,000,000 (Y), then the Conversion Price is $1.00 (CP). The $50,000 investment would convert into 50,000 shares (S).

50,000 shares = $50,000 / $1.00 because the conversion price equals $1,000,000 / 1,000,000 

Now, let’s increase the valuation cap to see the impact it has on the number of shares issued to the investor. 

Example 2: Using the Valuation Cap (again) 

If an investor purchased a SAFE for $50,000 (P) with a $10,000,000 Valuation Cap (X), and the Company has a Company Capitalization of 1,000,000 (Y), then the Conversion Price is $10.00 (CP). The $50,000 investment would convert into 5,000 shares (S).

5,000 shares = $50,000 / $10.00 because the conversion price equals $10,000,000 / 1,000,000 

Immediately, you can see the magnifying effect the valuation cap has on the resulting number of shares of preferred stock issued to the investor. 

Shifting Focus: Company Capitalization 

In explaining the valuation cap formula above, I made the mistake that I see many founders make: I only focused on the conversion price’s numerator (the valuation cap, X) and I ignored the conversion price’s denominator (the company capitalization, Y).

But, what if, instead of manipulating the conversion price by increasing or decreasing the valuation cap, X, we negotiated a more advantageous company capitalization, Y? That is, what if we increased or decreased the denominator of the conversion price formula?

What is Company Capitalization?

First, “company capitalization” is an agreed upon value representing the number of shares the company has issued. Y Combinator’s standard definition includes an aggregate of the following shares (but remember, parties can negotiate this definition): 

1. All shares of capital stock issued and outstanding; 
2. All converting securities, such as SAFEs and convertible notes; 
3. All granted stock options; and 
4. All shares reserved for future grant under the company’s option plan.

Example 3: Using Company Capitalization 

Using Y Combinator’s standard definition above, a company with 900,000 shares of common stock outstanding, no SAFEs or convertible debt, no options granted, and 100,000 shares reserved for issuance in the Company’s option pool has a “company capitalization” of 1,000,000. Remember, “company capitalization” is an aggregate of A through D above. 

If an investor purchased a SAFE for $50,000 (P) with a $1,000,000 Valuation Cap (X), and the Company has a Company Capitalization of 1,000,000 (Y), then the Conversion Price is $1.00 (CP). The $50,000 investment would convert into 50,000 shares (S).

50,000 shares = $50,000 / $1.00 because the conversion price equals $1,000,000 / 1,000,000 

Now, what if we changed the definition of “company capitalization” to exclude the shares we reserved for issuance in our option pool, but never issued?

Example 4: Excluding Option Pool Shares 

If the definition of “company capitalization” excludes shares reserved for issuance under the company’s option plan, a company with 900,000 shares of common stock outstanding, no SAFEs issued, no options granted, and 100,000 shares reserved for issuance in the Company’s option pool has a Company Capitalization totaling 900,000. 

If an investor purchased a SAFE for $50,000 (P) with a $1,000,000 Valuation Cap (X), and the Company has a Company Capitalization of 900,000 (Y), then the Conversion Price is $1.11 (CP). The $50,000 investment would convert into 45,000 shares (S). 

45,000 shares = $50,000 / $1.11 because the conversion price equals $1,000,000 / 900,000 

This definitional change of “company capitalization” caused a 10% decrease in the number of shares of preferred stock issued to the investor. 

Putting a Cap On It

Negotiating a financing is anything but “simple.” This article was written to help you with one of those challenges by explaining the mechanics of a Valuation Cap SAFE, including the impacts that a negotiated definition of “company capitalization” can have on the outcome of an investment. There are many considerations when negotiating a SAFE, but one of the best negotiating tactics is understanding how even a small change can make big differences. 

Gabriel Riekhof is an attorney at Husch Blackwell, a leading law firm that provides unparalleled service and industry-specific solutions to clients nationwide. He has experience working with entrepreneurs, investors and corporations on various aspects of equity financing, including angel, venture, and crowdfunding deals. He has helped clients raise capital, grow their businesses, and successfully exit.