SAFEs vs Convertible Notes: How Early Startup Funding Really Works

A brand-new startup is almost impossible to value. It may have a prototype, a few users and a team, but no revenue history. Rather than argue over a precise share price, most US founders and early investors use one of two instruments that postpone the price: the SAFE and the convertible note. Both turn into shares later, at the first priced round, usually on favorable terms for the early investor.

The basic idea

An early investor hands over cash today. In exchange, they get the right to shares later, when a lead investor sets a price in a priced round (often the Series A or a priced seed). Because the early investor took more risk, they receive a better price than the new investors, usually through a valuation cap, a discount, or both.

What a SAFE is

The SAFE, or simple agreement for future equity, was introduced by the accelerator Y Combinator in 2013 and revised in 2018 into the now-common post-money SAFE. Y Combinator publishes the standard forms on its website, and many investors use them with few changes.

Key features:

• Not debt. No interest, no maturity date, no repayment obligation in the normal course.
• Converts into preferred stock at the next priced round.
• Valuation cap and/or discount set the conversion price.
• Short and standardized, which keeps legal costs low.

What a convertible note is

A convertible note is a loan designed to convert into equity rather than be repaid. It has:

• An interest rate, which accrues and usually converts into shares along with the principal.
• A maturity date, by which the note is due if it has not converted. In practice, startups and investors often extend maturity rather than demand repayment, but the investor technically has a creditor's position.
• A valuation cap and/or discount, like a SAFE.

Side by side

Caps and discounts, explained

Valuation cap. The maximum valuation at which the investor's money converts. If the priced round values the company above the cap, the investor converts as if the valuation were at the cap, getting more shares.

Discount. A percentage off the price paid by new investors in the priced round.

When an instrument has both, the investor generally gets whichever produces the lower price per share, and therefore more shares.

A worked example

Purely illustrative numbers, with simplifications:

• An angel invests $100,000 on a SAFE with a $5 million post-money valuation cap and no discount.
• Under a post-money SAFE, that investor's ownership just before the priced round is $100,000 ÷ $5,000,000 = 2% of the company (before the new round's dilution).
• Later, a Series A lead invests at a $15 million pre-money valuation.

Because the round's valuation is above the cap, the angel converts at the cap, paying a price per share well below what the Series A investors pay. Then the new Series A shares dilute everyone, including the angel, proportionally.

Change one number, such as a priced round below the cap, and the result is quite different: the angel would convert at the round's price, or at a discount if there is one. This sensitivity is why founders and investors should model several scenarios with a cap table tool before signing.

The dilution trap for founders

SAFEs are easy to raise, one at a time, from different investors, often with different caps. That convenience can hide how much of the company has been promised.

• With post-money SAFEs, each SAFE investor's percentage is fixed relative to the post-money cap, so additional SAFEs dilute the founders rather than the earlier SAFE holders.
• Several SAFE rounds stacked before a Series A can add up to a large ownership stake that only becomes visible at conversion.
• The option pool created at the priced round dilutes founders further.

The fix is simple: keep a pro forma cap table that shows ownership after all SAFEs convert, and update it with every new SAFE.

Common terms you will see in the documents

Beyond the cap and discount, a few other clauses come up often:

• Most-favored-nation (MFN). If the company later issues SAFEs or notes on better terms, the MFN holder can adopt those terms. Common on uncapped SAFEs.
• Pro rata side letter. Gives the investor the right to buy into the next priced round to maintain their ownership.
• Liquidity event clause. Explains what happens if the company is acquired before a priced round, typically giving the investor the choice of cash back or conversion.
• Dissolution clause. Sets where SAFE holders stand if the company shuts down, generally behind creditors.
• Qualified financing threshold (in notes). Defines how large a priced round must be to trigger automatic conversion.

Small wording differences in these clauses can shift outcomes, so read them rather than assuming the standard form was used unchanged.

Things angel investors should check

For individuals investing, especially through crowdfunding portals, the SEC has warned that SAFEs may never convert and that terms vary widely. Before investing:

• Read the conversion triggers. Some SAFEs sold to the public convert only on events that may never happen.
• Check the cap and discount and whether there is a most-favored-nation clause, which gives you better terms if later SAFEs get them.
• Understand pro rata rights, if any, to invest in future rounds.
• Expect illiquidity. You generally cannot sell a SAFE, and it pays nothing until conversion or a sale.
• Assume loss is possible. Most startups fail. Invest only money you can afford to lose.

Securities rules still apply

Both SAFEs and convertible notes are securities. Companies offering them must comply with federal and state securities laws, usually through exemptions such as Regulation D for accredited investors or Regulation Crowdfunding for offerings through registered portals. A securities lawyer can advise which exemption fits and what filings are needed.

Which to use?

• SAFE: faster, cheaper, founder-friendly, and the default for many US early-stage rounds, particularly with investors familiar with the standard forms.
• Convertible note: preferred by some investors who want a creditor position and interest, and more common in some regions and sectors.
• Priced seed round: sometimes better when a large amount is raised from a lead investor who wants board representation and clear ownership from the start.

Whatever the instrument, the habits that protect both sides are the same: use standard documents where possible, model the conversion under several scenarios, and keep the cap table current. The paperwork may be simple, but the ownership consequences last for the life of the company.