SAFEs and Convertible Notes Explained
Convertible instruments let you raise without setting a valuation. Here's how they work.
SAFEs and convertible notes are popular for early-stage fundraising. They’re faster and simpler than priced rounds, but they come with trade-offs. Understanding how they work helps you make better decisions.
What Are Convertible Instruments?
The Basic Concept
Instead of selling shares at a fixed price, you sell the right to shares in the future.
Now: Investor gives you money.
Later: Money converts to shares when you raise a priced round.
Why They Exist
Faster: No need to negotiate full terms.
Cheaper: Less legal work.
Avoids valuation: Don’t set a price when it’s hard to determine.
Common for pre-seed, seed, and bridge rounds.
SAFEs (Simple Agreement for Future Equity)
How SAFEs Work
Created by Y Combinator. Most common for early rounds now.
Key features:
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Not debt (no maturity, no interest)
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Converts to equity at next priced round
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Simple 5-page document
SAFE Types
Post-money SAFE (Current Standard):
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Cap is based on post-money valuation
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Investor knows exactly what % they’ll own
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Cleaner for founders to model
Pre-money SAFE (Older Version):
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Cap is based on pre-money valuation
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Investor % depends on how much is raised
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More complex to model
SAFE Terms
Valuation Cap:
Maximum valuation at which the SAFE converts.
Example: $5M cap means if next round is at $10M valuation, SAFE converts at $5M (investor gets more shares).
Discount:
Discount to next round’s price.
Example: 20% discount means investor pays 80% of what new investors pay.
Most Favored Nation (MFN):
If you issue better terms to later investors, earlier investor gets those terms too.
SAFE Conversion Example
SAFE: $500K at $5M post-money cap
Series A: $10M pre-money, $2M raised, $12M post-money
SAFE Conversion:
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SAFE converts at $5M cap (better than $10M pre-money)
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$500K / $5M = 10% on a post-money basis
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But SAFE is post-money on SAFE round, so exact calculation depends on specifics
Result: SAFE investor gets more shares than if they’d waited for Series A.
Convertible Notes
How Notes Work
Convertible notes are debt that converts to equity.
Key features:
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Actually debt (legal obligation to repay)
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Has maturity date
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Accrues interest
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Converts at next priced round
Note Terms
Principal: Amount invested.
Interest Rate: Typically 5-8% annually.
Maturity Date: When note is due if not converted. Typically 18-24 months.
Valuation Cap: Maximum conversion price.
Discount: Discount to next round’s price.
Note Conversion Example
Note: $500K principal, 6% interest, 2-year maturity, $5M cap, 20% discount
After 1 year, Series A at $8M pre-money:
Interest accrued: $500K × 6% × 1 year = $30K
Total converting: $530K
Conversion price (cap): $5M cap
Conversion price (discount): $8M × 0.80 = $6.4M
Note uses cap ($5M) because it’s lower (better for investor).
Notes vs. SAFEs
Feature
SAFE
Note
Legal structure
Equity
Debt
Maturity date
No
Yes
Interest
No
Yes
Repayment obligation
No
Yes
Complexity
Lower
Higher
SAFEs are simpler and more founder-friendly.
Key Terms to Understand
Valuation Cap
The maximum valuation at which the instrument converts.
Lower cap = better for investor.
If cap is $5M and Series A is at $10M, investor converts at $5M price (getting 2x the shares).
Discount
Alternative way to price conversion.
Typical: 15-25%
If Series A price is $2/share with 20% discount, convertible holder pays $1.60/share.
Which Triggers: Cap or Discount?
Investor gets the better of cap or discount.
Example:
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Cap: $5M
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Discount: 20%
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Series A: $8M pre-money
Cap price: ~$0.50/share (assume $5M / 10M shares)
Discount price: ~$0.64/share (20% off $0.80)
Investor uses cap (lower price = more shares).
Pro-Rata Rights
Right to invest in future rounds.
Common: Major investors get pro-rata.
Less common: All SAFE holders get pro-rata.
Stacking SAFEs
The Problem
Multiple SAFEs at different caps:
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First SAFE: $500K at $5M cap
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Second SAFE: $500K at $8M cap
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Third SAFE: $500K at $10M cap
They all convert at Series A, diluting each other.
Modeling It
Use a cap table tool to model exactly.
Post-money SAFEs make this cleaner:
Each investor knows their exact %.
How Much Is Too Much?
Guidelines:
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Total convertible < 20-25% of anticipated round
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Understand fully diluted ownership before raising more
Stacking too much creates founder dilution problems.
When to Use Each
Use SAFEs When
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Very early stage
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Speed matters
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Valuation is genuinely unclear
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Standard early-stage dynamics
Use Convertible Notes When
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Certain investors require it (some angels, some institutions)
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Bridge loans
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Debt structure preferred for some reason
Use Priced Round When
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Raising significant amount ($3M+)
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Valuation is clear
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Want clean ownership
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Investors prefer it
Common Mistakes
No Cap
Giving uncapped SAFE = unlimited dilution if you raise at high valuation.
Fix: Always have a cap.
Too Many SAFEs
Stacking so many that founder dilution is severe.
Fix: Model your cap table. Know fully diluted ownership.
Not Modeling Conversion
Not understanding how conversion works.
Fix: Use cap table tool. Model before signing.
Ignoring MFN
Giving better terms later without understanding MFN impact.
Fix: Know which investors have MFN. Understand implications.
Forgetting Interest on Notes
Interest accrues and converts.
Fix: Track interest. Include in models.
Key Takeaways
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SAFEs and notes let you raise without setting valuation now
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SAFEs: simpler, not debt, no maturity—most common for early stage
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Notes: actual debt, has maturity and interest—still used but less common
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Valuation cap: maximum price at which instrument converts—lower cap = better for investor
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Discount: alternative conversion pricing—typically 15-25%
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Investor gets better of cap or discount
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Post-money SAFEs are cleaner for understanding ownership
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Don’t stack too many convertibles—model your cap table
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Always have a cap—uncapped SAFEs create unlimited dilution risk
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Model conversions before signing—understand your fully diluted ownership
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