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Understanding SAFEs and Convertible Notes

SAFE vs. Convertible Note: Key Differences

A SAFE (Simple Agreement for Future Equity) and a convertible note both allow early-stage investors to fund a startup now and receive equity later, typically when a priced round occurs. Despite their similar purpose, they differ in important ways.

A convertible note is debt. It carries an interest rate, has a maturity date, and legally the startup owes the investor money until conversion. If the note matures before a qualifying round, the investor can theoretically demand repayment, although in practice this usually triggers a negotiation rather than a bankruptcy filing.

A SAFE is not debt. Invented by Y Combinator in 2013, it has no interest rate, no maturity date, and no repayment obligation. It simply converts into equity when a triggering event occurs, most commonly a priced equity round. This makes SAFEs simpler and cheaper to execute because there are fewer terms to negotiate and no accruing interest to track.

Valuation Cap Explained

The valuation cap is a ceiling on the price at which the investor’s money converts into equity. It is not a valuation of the company. If the startup raises its next round at a $20 million pre-money valuation but the SAFE has a $5 million cap, the SAFE holder converts as if the company were valued at $5 million. This means they get four times as many shares as the new investors per dollar invested.

The cap exists to reward early investors for taking on more risk. When the company was worth almost nothing, these investors wrote a check. In exchange, they get a guaranteed maximum price regardless of how valuable the company becomes before the next priced round.

Discount Rate Explained

The discount rate gives the early investor a percentage reduction on whatever price the new investors pay. A 20% discount means the SAFE or note holder pays 80 cents on the dollar. If the Series A price per share is $1.00, the converting investor pays $0.80.

The discount is most valuable when the next round’s valuation is relatively close to the cap. If the company raises at a $6 million valuation with a $5 million cap and a 20% discount, the discount price ($6M × 0.80 = $4.8M effective) actually beats the cap. The investor always gets whichever conversion method produces more shares.

When the Cap Matters vs. When the Discount Matters

The relationship is straightforward. As the pre-money valuation of the next round increases, the discount price rises proportionally while the cap price stays fixed. At some crossover point, the cap becomes the better deal.

For example, with a $5 million cap and a 20% discount, the crossover happens at a $6.25 million pre-money valuation. Below $6.25M, the discount wins. Above $6.25M, the cap wins. This is why savvy investors negotiate for both: they want the discount to protect them at moderate outcomes and the cap to protect them at high outcomes.

Pro-Rata Rights and MFN Clauses

Pro-rata rights give the SAFE or note holder the option to invest additional money in the next round to maintain their ownership percentage. Without pro-rata rights, the investor gets diluted alongside the founders when new money comes in.

A Most Favored Nation (MFN) clause protects early SAFE holders when the company issues subsequent SAFEs with better terms. If a later investor gets a lower cap or a higher discount, the MFN clause lets the earlier investor adopt those improved terms. This prevents the company from slowly giving away better deals at the expense of its earliest supporters.

Common Mistakes

• Setting the cap too high. If the cap is close to or above the expected Series A valuation, it provides little benefit to the investor. Early investors are taking the most risk and should receive a cap that meaningfully rewards that risk. A cap that is too generous to the founders can deter sophisticated investors.
• Ignoring the dilution stack. Founders often issue multiple SAFEs or notes before a priced round. Each one converts into equity, and the cumulative dilution can be far greater than any single instrument suggests. Modeling the full stack, including all outstanding SAFEs, notes, and the option pool, is critical before agreeing to new terms.
• Forgetting about interest on convertible notes. A 5% interest rate on an 18-month note adds 7.5% more converting principal. On a $500,000 note, that is an extra $37,500 worth of shares the founders are giving away. Over longer time horizons or higher rates, this compounds significantly.
• Not modeling different outcomes. A SAFE or note looks different at a $5 million Series A versus a $50 million Series A. Run the numbers at multiple valuations to understand best-case and worst-case dilution scenarios before signing.