What is Shadow Stock?

What is Shadow Stock?

For founders and investors using SAFEs, this post explains the mysterious “Shadow Stock” or “SAFE Stock.” “Shadow Stock” is a series of preferred stock that is created when a SAFE converts into equity at the triggering priced round. 

First, Shadow Stock Phantom Stock

Shadow Stock is often confused with Phantom Stock, likely because of the mysterious names. However, they should not be used interchangeably as they are not the same.

Most importantly, phantom stock is not actually stock; it is a form of equity compensation given to key employees entitling them to benefits that act like stock (explained more here).

Shadow stock is a real class of stock that shadows a series of preferred stock, with all of the same rights and preferences as the stock it shadows, but with a couple differences that correlate to the price per share actually paid for the shadow stock (which is lower than the price per share paid for the preferred that it shadows, as explained in more depth below).

You can remember the difference this way:

Phantoms are not real. A phantom is something that seems real, but does not actually exist. 

Phantom Stock: a faux “stock-like” equity incentive given to key employees instead of real stock (to avoid dilution). 

Shadows are real. (basically). A shadow is a dark shape caused by the blocking of a light source; a shadow will have the same shape as the object causing it.

Shadow Stock: a real class of stock that shadows a series of preferred stock and is created at the conversion of the SAFE into equity in the company (when there is a preferred round that converts the SAFE). It is a sub-series of preferred stock.  

Back to Basics: Why SAFEs Were Created

To understand why a “shadow” series of preferred stock is created for SAFE conversions, it helps to understand why SAFEs were created by Y Combinator in the first place. A “SAFE” (“Simple Agreement for Future Equity”) is more than just a simplified, standardized alternative to traditional convertible notes. SAFEs were also designed to deal with several issues that arise with traditional convertible notes.

For legal purposes, convertible notes are considered “debt instruments” rather than equity because repayment is a potential outcome. Generally, a convertible note will either be (a) converted into equity in the company at a “qualified financing” (a priced round above a certain amount as set forth in the note), or (b) repaid by the startup, plus accumulated interest (like a loan).

If the conversion trigger never happens, the company is obligated to repay the convertible note holder at the maturity date specified in the note (plus interest). The maturity date eliminates some of the risk for the investor, and causes the convertible note to act more like a loan (debt). Regulations and requirements for debt instruments can make life more complicated for a startup.

SAFEs on the other hand, are not considered debt instruments because SAFEs do not have a maturity date and are never repaid (very unlike a loan). SAFEs will only convert into equity if the company has a priced round. If there is no priced round, then nothing happens.

Not using a debt instrument to raise funds alleviates certain regulatory issues and financial pressures for the company. For example, a looming maturity date may divert the founder’s focus from R&D toward raising an equity financing round above the amount required to trigger conversion of the note, which the company may not be ready for. Rushing a financing deal is not a good position for the startup. Or, the founders may focus solely on achieving enough profitability to be able repay the loan (if it can) or become insolvent.

Aside from these debt related issues, traditional convertible notes also have some “unfairness” issues.

Liquidation Preference Issues in Convertible Notes

SAFEs and convertible notes can have a valuation cap and/or a discount rate. If the instrument contains both, it will convert at whichever method gives the holder a lower purchase price per share (better deal).

And, this is where SAFEs and traditional convertible notes diverge in their conversion mechanics:

At the triggering financing, convertible notes are issued the exact same series of preferred stock as the priced round investors, so that there is only one new preferred series on the cap table. Therefore, the convertible note holder will receive the exact same liquidation preference as the new investors.

This means that, in a liquidation event, all of the preferred stock in this series will be paid out based on the “original issue price” (the price per share paid by the new investors). However, the convertible note holders paid a lower price per share than the new investors due to the convertible note’s valuation cap or discount rate, whichever was used. Thus, the convertible note holders paid less per share for the preferred stock than the priced round investors, but will get the same payout as the priced round investors.

For example, let’s say that the new investors paid $1.00 per share and the convertible note holders (who had a 20% discount) actually paid $0.80 per share. Now, the convertible note holders will be paid out as if they had paid $1.00 per share. In other words, they will get more payout than they are entitled to because the payout amount is not pegged to the amount they actually paid per share.

SAFE Conversions: Shadow Stock 

Conversely, when a SAFE converts into equity, a shadow series of preferred stock called the “SAFE Preferred Stock” is issued to the SAFE holders (“the Investor”) and is distinguished from the preferred stock issued to the priced round investors (“investors investing new money in the Company”) by the creation of a separate series of preferred stock called the “Standard Preferred Stock.”

Safe Preferred Stock” means the shares of the series of Preferred Stock issued to investors in an Equity Financing, having the identical rights, privileges, preferences, and restrictions as the shares of Standard Preferred Stock, other that with respect to: (i) the per share liquidation preference and the initial conversion price for purposes of price-based anti-dilution protection, which will instead equal the [discount or valuation cap]; and (ii) the basis for any dividend rights, which will be based on the [discount or valuation cap]. 

Standard Preferred Stock” means the shares of the series of Preferred Stock issued to investors in investing new money in the Company in connection with the initial closing of the Equity Financing. 

In startup law, the “SAFE preferred stock” issued to the SAFE holders (“the Investor””) is also called “shadow stock,” “shadow preferred stock,” or “sub-series preferred stock” (called just “shadow stock” in this post for simplicity).

On the startup’s cap table, the shadow stock may be under a sub-label (e.g., “Series A” for the standard preferred, and “Series A-1” for the shadow preferred), or it may be labeled as a separate series (e.g., “Seed-1” for the new money investors, and ‘Seed-2’ for the SAFE investors). The labeling is just semantics and generally just depends on the lawyer’s preferences.

The new shadow stock has “identical rights, privileges, preferences and restrictions as the Standard Preferred Stock” . . . with an important exception – the calculation for the liquidation preference and any dividend will equal the “Discount Price.”

The Discount Price is based on the original issue price that the SAFE holder actually paid for the shares when the SAFE converted, not the price paid by the priced round investors (e.g., $0.80 per share for the SAFE holders vs $1 for the new money investors).

Thus, the liquidation preference and any dividend owed to the shadow stock (SAFE investors) correlates to the amount the SAFE holder actually paid to purchase the preferred shares in the startup in the conversion of the SAFE, which solves an inequity caused by the mechanics of convertible notes and is considered much more fair for the priced round investors and the common shareholders (the founders and employees).

It should be noted that many startup lawyers (but not all) now add a shadow stock clause to traditional convertible notes to resolve this issue. If you are raising funds through a convertible note round, be sure to discuss this issue with your lawyer.

Disclaimer The information on this website is meant to be used for general educational purposes only. This information may not reflect the current law in your jurisdiction and should not be construed as legal or business advice or an advertisement for legal services. You should not act or refrain from acting on the basis of any information in this post or accessible through this website. If you have questions regarding your particular facts and circumstances, seek counsel from an experienced startup lawyer.

Pre-Money vs Post-Money SAFEs

Pre-Money vs Post-Money SAFEs

Understanding the difference between the two SAFE versions and general issues with SAFEs can help you decide if it is...

Pre-Money vs Post-Money SAFEs

Pre-Money vs Post-Money SAFEs

Understanding the difference between the two SAFE versions and general issues with SAFEs can help you decide if it is right for your financing, and if so, which version to use.

  • Key differences between Pre-Money and Post-Money SAFEs.
  • When each SAFE version should be used and why.
  • General issues with SAFEs.

Origins of the SAFE – Pre-Money SAFE

The Simple Agreement for Future Equity (“SAFE”) was released by a Y Combinator lawyer in 2013 to provide a simple, standard instrument that could be used to invest in early-stage, bootstrapped startups prior to a larger priced round (usually labeled a “Series A round”). SAFEs were meant to be an alternative to the issues that arise with convertible notes which were the most common early-stage investment instrument.

The original version is known as the “Pre-Money SAFE” as the valuation of the company is determined “pre-investment” (the cash the SAFE investors are adding to the company is not included in the valuation). The Pre-Money version of the SAFE is no longer available for download on YC’s website, but cap table management company, Carta, now allows its users to automate either SAFE version via their platform.

SAFE 2.0 – Post-Money SAFE

The second version of the SAFE, released in 2018, is known as the “Post-Money SAFE” because the valuation is “post-investment” (the cash the SAFE investors are adding to the company is included in the company’s valuation).

YC also corrected issues that arose with the original version. Certain clauses were reformatted for clarity. A group of SAFEs can now be treated as a financing round (rather than each SAFE a stand-alone investment), and only a majority-in-interest of the SAFE holders in that round is required to make an amendment to all SAFEs in that round. This makes it much easier for the company to obtain consent from a majority of the SAFE holders in a round rather than each individual SAFE holder.

The Post-Money SAFE is available for download here.

Both SAFE versions can have either a valuation cap and/or a discount rate. If the SAFE has both options, it will convert at whichever method gives the SAFE holder a lower purchase price per share (more shares). Or, the SAFE can have a most favored nation (MFN) clause which entitles the SAFE holder to the terms as any more favorable future convertible security issued by the company in the future (more on SAFE conversions in a future post)

Post-Money: Dilution

It is crucial to understand the dilutive impact of the Post-Money SAFE on founders. In the simple division problem for the Safe price (below) the definition of the denominator, “Company Capitalization,” has changed.

In the Post-Money SAFE, a new term, “Converting Securities,” has been added to the “Company Capitalization.” Converting Securities include the SAFE at hand, all other SAFEs (from all rounds) and any other convertible securities prior to the priced round that triggers conversion of the SAFE.

This means that all SAFEs and any other convertible securities increase the denominator. The larger the denominator, the lower the Safe price will be. The lower the Safe price (price per share), the more shares the SAFE holder will get when the SAFE converts into equity (and the more dilution the common shareholders will suffer).

Under the Pre-Money SAFE, all shareholders (founders, employees, and investors alike) bore equal dilution for any subsequent rounds based on their percentage of ownership. Under the Post-Money SAFE, only the common shareholders (usually founders and early employees) absorb dilution from any future SAFE or other convertible securities until a priced round (while the SAFE investors are not diluted at all).

This is equivalent to “full-ratchet” anti-dilution for SAFE investors. Full-ratchet anti-dilution is a mechanism used to protect investors if the company had a down-round (lower valuation), and is considered so unfair that it is rarely ever included in modern fundraising agreements. With the Post-Money SAFE, full-ratchet anti-dilution is automatic, even when the company has a higher valuation in future rounds and there is no justification for this type of investor protection.

Pre-Money: Default Pro Rata Rights

A pro rata right is a right (but not an obligation) of an investor to invest in future financings to maintain their same percentage of ownership. Pro rata rights can be full or partial and can have triggers and/or limitations (e.g., limited to only certain funding rounds). When non-standard fundraising documents are used, pro rata rights are normally a point of negotiation.

Under the original Pre-Money SAFE, by default, every SAFE holder gets a pro rata right to purchase its pro rata share of stock in the company after the equity financing (after the SAFE has converted in equity), but no pro rata right to participate in other convertible securities. This is really odd.

This means that if the company has a Series A financing, the SAFE holders have the right to invest in a subsequent financing (usually a “Series B,” and so on). The issue is that SAFE investors are generally Angel investors who typically do not have the type of capital to meaningfully participate in a Series B or later round. Additionally, Series B investors often negotiate to remove prior pro rata rights anyway. But, the SAFE holders have no pro right to invest in any other pre-Series A round (when they would likely prefer to invest).

Under the new Post-Money SAFE, by default, no investors get pro rata rights (at any round). Any pro rata right must be granted by the company and are outlined in a side letter with each individual investor who has the right (rather than editing the SAFE). This allows the company to place its own contingencies on the pro rata right and to favor more valuable and/or bigger investors (only SAFEs in the amount of $100K+, etc.).

Choose a SAFE Based on  Fundraising Amount

Use logic when deciding which version of the SAFE is best for financing round. Consider the amount of money the company intends to raise in the round and how many convertible rounds will necessary prior to an equity round. For example: 

Funding Round: < $1M Pre-Money SAFE

If the company is raising less than $1M in today’s fundraising environment, there will likely be another convertible round before a priced round. In this case, the Pre-Money SAFE may be the most fair as all shareholders will bear their relative portion of dilution in any future convertible round.

Funding Round: $1M to $3M It Depends

If the company is raising between $1M to 3M and is uncertain as to whether another convertible funding round will be necessary, then it is probably better to use a Pre-Money SAFE, if possible. In this range, the investors may push for the Post-Money SAFE version. The version ultimately used will likely depend on the overall level of investor interest in the company, the value the specific investors bring to the company, and the sophistication of the investors and each parties’ legal team. 

Funding Round: > $3M It Depends

If the company is raising more than $3M, then more experienced investors (and their legal team) will be more involved. This size investor will likely only invest through the Post-Money SAFE. Fortunately, a $3M+ funding round shows investor confidence in the company and if the money is used wisely, a priced round may follow and avoid the harsh dilution that subsequent convertible rounds would create. Because pro rata rights are not defaul in the Post-Money SAFE, the company can grant the ant-dilution right to only the lead investors in the SAFE round rather than every investor in the SAFE round. 

Note that each of the examples above are general examples based on the current startup investment climate, but may not be applicable to your company (e.g., $1M may be enough of a bridge prior to an equity round). Base your fundraising needs on your specific industry, business model, business plans, region, burn rate, etc.

Everybody is Doing It – It Must be SAFE

The SAFE has become wildly popular for early-stage startup fundraising:

There are many good reasons why SAFEs are used so frequently, including: 

  • Lower transactions costs (a priced round can easily cost $50K in legal fees)
  • Transaction can be completed quickly (usually less than a week)
  • Kick the company’s valuation down the road when its ready (has revenue)
  • None of the regulatory issues that arise with debt/convertible notes
  • No maturity date means no looming repayment date or pressure to raise VC funds
  • No interest rate, so the equity conversion will equal the SAFE amount, and no more
  • The Post-Money SAFE makes it easy to keep track of equity/dilution

But, Nothing is SAFE

Despite YC’s best efforts, the SAFE has had legitimate criticism from both startups and investors. Anyone considering the SAFE for a fundraising or investment, should be aware of these issues.

For one, the SAFE was only intended to be used as a short-term bridge (a.k.a. “seed round”) prior to a priced round (meaning, one seed round, not multiple seed rounds). The SAFE’s efficiency and lack of maturity date has certainly been abused by some startups.

(if you know Harry’s podcast, The Twenty Minute VC, you read that in a British accent).

Of course, there are consequences.

Because convertible securities are generally not listed on cap tables, founders are often surprised by how much equity they’ve actually given away, the effects of which are not fully felt until the first priced round when the instruments convert.

The harsh dilutive effects of the Post-Money SAFE were indeed intended to create accountability and curb infinite convertible rounds.

If your company has any convertible securities rounds, it is very important to track dilution through an experienced startup lawyer and/or a cap table management platform.

SAFEs Have Become Ubiquitous

The word “SAFE,” formed by the agreement’s acronym, is now a generic term used to describe all types of convertible instruments, including edited “SAFEs.” This has exasperated YC’s original intent of providing a simple, standard agreement. Transaction costs have increased as lawyers spend more time deciphering these edits and SAFE-like agreements.

That said, standard documents are not one size fits all and the standard SAFE may not fit a startup’s fundraising needs or survive negotiations with investors.

SAFEs Were Created for Future Venture-Backed Startups

Neither version of the SAFE has a maturity date. YC intentionally omitted the maturity date to eliminate regulatory issues that arise with debt instruments and the pressure to have an equity round before the startup is ready (unlike convertible notes).

However, this means that if the startup never has an equity fundraising (the triggering event), then the SAFE never converts into equity in the company. The SAFE is not repaid. Nothing happens. Investors, read that again.

Now, take into account recent trends: cloud storage costs have plummeted with the use of overseas servers. Talented engineers can be hired as remote independent contractors from anywhere in the world. Technology has enabled significant cost reductions for creating and operating companies. This means that some SaaS startups can become profitable more quickly and may never need to or choose to take venture capital.

While it is possible for a startup to have a smaller, non-VC priced round that would convert the SAFE into equity, the SAFE investors would likely not get much of a discount. Lesson for SAFE investors: make sure that raising venture capital is in the company’s business plans. Surprisingly few Angel investors ask this question.

To be fair, while convertible notes do have a maturity date, in most cases seed funds are spent quickly and startups would not be able to repay the note amount if called in by investors. Therefore, the maturity date likely provides an illusory sense of security anyway.

Disclaimer: The information on this website is meant to be used for general educational purposes only. This information may not reflect the current law in your jurisdiction and should not be construed as legal or business advice or an advertisement for legal services. You should not act or refrain from acting on the basis of any information in this post or accessible through this website. If you have questions regarding your particular facts and circumstances, seek counsel from an experienced startup lawyer.

Pre-Money vs Post-Money SAFEs

Pre-Money vs Post-Money SAFEs

Understanding the difference between the two SAFE versions and general issues with SAFEs can help you decide if it is right for your financing, and...