Dror Futter, a legal counsel to leadership teams, highlighted a subtle but significant shift in the venture capital landscape, as revealed by Carta’s 2024 Pre-Seed Funding Review.
The review noted a surprising/unexpected trend in Q4: a decreasing percentage of Simple Agreements for Future Equity (SAFEs) structured as “cap only.”
This observation, Futter acknowledges, initially flew under his radar but offers critical insights into investor behavior, market dynamics, and the evolving sophistication of the startup ecosystem.
For context, SAFEs, popularized by Y Combinator, are a common tool for early-stage fundraising.
Y Combinator’s post-money SAFE, more prevalent than its pre-money predecessor, comes in three primary flavors: cap only, discount only, and most favored nation (MFN).
The MFN option is rarely used, but a notable portion of SAFEs incorporate a “best of” formulation—combining a cap and a discount to yield the most favorable share conversion for investors.
This cap+discount structure, while not part of Y Combinator’s standard templates, has been adapted by lawyers to align with post-money SAFE frameworks, drawing inspiration from earlier pre-money versions.
The choice of the SAFE structure depends heavily on market conditions. In a rising market, investors prefer cap-only SAFEs, as caps limit dilution by setting a maximum valuation for share conversion. In a falling market, however, discounts reward early investors by allowing them to purchase shares at a lower price than the next round’s valuation.
The cap+discount formulation is the investor’s ideal scenario, offering benefits in both rising and falling markets.
This flexibility maximizes returns while mitigating risk, making it the most investor-friendly option.
What puzzled Futter was the multi-year trend—until Q4—of increasing cap-only SAFEs despite a prolonged slump in the venture market.
In a down market, cap-only SAFEs are less advantageous for investors. If valuations drop, these SAFEs convert at the next round’s price, offering no premium for the risk taken by early backers.
This trend seemed counterintuitive, as one would expect investors to favor discounts or cap+discount structures to secure better terms in a declining market.
Futter’s hypothesis for this anomaly points to investor demographics.
He suggests that inexperienced investors, possibly lacking seasoned advisors, may have gravitated toward cap-only SAFEs because they are a standard, founder-friendly Y Combinator template.
In a down market, founders benefit from cap-only structures, as they avoid offering discounts that would increase investor ownership.
The prevalence of cap-only SAFEs, therefore, may reflect a lack of investor sophistication rather than a strategic choice.
The Q4 decline in cap-only SAFEs, however, signals a potential shift.
If this trend continues, it could indicate growing investor savvy, as more backers demand terms like discounts or cap+discount formulations that better align with market realities.
Such a development would be a positive sign for the startup ecosystem, suggesting that investors are becoming more discerning and better equipped to negotiate terms that reflect their risk.
Looking ahead, Futter is eager to monitor whether this trend solidifies.
A sustained decrease in cap-only SAFEs could potentially lead to a more balanced and mature venture market, where investors prioritize structures that reward early risk-taking.
In summary, Carta’s 2024 review offers a glimpse into the interplay of market conditions, investor experience, and the evolving ecosystem of early-stage fundraising.