SAFEs, Notes & Convertibles
The Hook
Early-stage money rarely buys shares directly. It buys a promise: give me cash now, and you get equity later, on terms set today. SAFEs and convertible notes are how most startups raise their first dollars, and the small print, the cap and the discount, quietly decides how much of your company those early backers really own.
Plain English
When a company is too young to know what it is worth, setting a price per share is hard. So early investors often use instruments that delay the pricing. A convertible note is a loan that converts into equity at a later priced round, often with interest. A SAFE (simple agreement for future equity) does the same thing but is not a loan, so there is no interest and no repayment date. Both convert into shares when a real priced round happens. The two terms that matter most are the valuation cap, the maximum company value at which the investor's money converts (a lower cap means they get more shares), and the discount, a percentage off the price the new round investors pay, rewarding the early backer for taking the risk first. An MFN clause lets an early investor adopt better terms if a later investor gets them. A QFR, the qualified financing round, is the priced round that triggers conversion. The point of all of it is to reward early money with more shares for the same dollars.
The Math
When a SAFE or note converts, you compare two possible prices and the investor gets the better (lower) one, which gives them more shares. The cap price comes from the valuation cap. The discount price comes from taking a percentage off the new round's price. Whichever is lower wins for the investor.
- Conversion price from the cap = valuation cap / company shares before conversion
- Conversion price from the discount = new round price per share x (1 - discount)
- Shares received = investment / the lower of the two conversion prices
An investor puts 100,000 dollars into a SAFE with a 20 percent discount and no cap. Eighteen months later the company raises a priced round at 10 dollars per share. The investor does not pay 10 dollars. With the 20 percent discount, their conversion price = 10 x (1 - 0.20) = 8 dollars per share. So their shares = 100,000 / 8 = 12,500 shares. A new investor putting in the same 100,000 dollars at the full 10 dollars gets only 10,000 shares. The early investor's reward for taking the risk first is 2,500 extra shares for the exact same money. That is the discount doing its job.
Now add a valuation cap. An investor puts 100,000 dollars into a SAFE with a 5,000,000 dollar cap and a 20 percent discount. The company does very well and raises its priced round at a 20,000,000 dollar valuation, which works out to 10 dollars per share. We compare the two prices. Discount price = 10 x (1 - 0.20) = 8 dollars. Cap price = cap divided by the share count, and because the cap (5,000,000) is far below the round valuation (20,000,000), the cap price comes out to about 2.50 dollars per share. The investor takes the lower price, 2.50 dollars, so their shares = 100,000 / 2.50 = 40,000 shares. The cap rewarded them enormously for backing a company that grew fast. When a company's valuation soars past the cap, the cap, not the discount, is what really matters.
Founders often raise on a pile of separate SAFEs and lose track of how much they have promised away. Say you raise 1,000,000 dollars across several SAFEs, all with a 5,000,000 dollar cap. When the priced round comes, all of those SAFEs convert at the cap price at once. Because they convert near the 5,000,000 cap, that 1,000,000 dollars of SAFE money converts into roughly 20 percent of the company (1,000,000 / 5,000,000), all landing before the new round investor even arrives. If you also negotiated an MFN clause for one early backer and later gave a better cap to someone else, that early backer can upgrade to the better terms too, increasing their share. The lesson: SAFEs feel painless because no price is set today, but they stack up, and you must model the full conversion before you sign the priced round, not after.
The Lingo
- Convertible note
- A loan to an early-stage company that converts into equity at a later priced round, usually carrying interest and a maturity date.
- SAFE (simple agreement for future equity)
- An agreement that converts into equity at a future priced round. Unlike a note, it is not a loan, so it has no interest or repayment date.
- Valuation cap
- The maximum company valuation at which an investor's money converts into shares. A lower cap means more shares for the investor.
- Discount
- A percentage off the price new investors pay in the priced round, rewarding early backers for taking the risk first.
- MFN (most favored nation)
- A clause letting an early investor adopt better terms if the company later offers more favorable terms to someone else.
- QFR (qualified financing round)
- The priced equity round large enough to trigger SAFEs and notes to convert into shares.
- Conversion
- The moment a SAFE or note turns from a promise into actual shares, at the better of the cap price or the discount price.
Practice
In the Room
The Trap
Treating SAFEs as free money because no price is set today. The price is set later, and the cap and discount decide how much of your company those early dollars buy. Founders who raise on a stack of uncapped or low-cap SAFEs are often shocked at how much ownership converts away at the priced round, all at once. Always model the full conversion before the round, account for the cap, the discount, and any MFN clause, and know your true post-conversion ownership before you sign.
Quick Check
Q1.What is the main difference between a SAFE and a convertible note?
Q2.What does a valuation cap do for an early investor?
Q3.An investor has a 20 percent discount and the priced round is at 10 dollars per share. What is their conversion price?
Q4.At a conversion price of 8 dollars per share, how many shares does a 100,000 dollar investment buy?
Q5.A SAFE has both a low cap and a discount, and the company's valuation soars far above the cap. Which term drives the investor's shares?
Practice Out Loud
You raised 1,000,000 dollars on SAFEs with a 5,000,000 dollar cap, and now a priced round is coming at a 20,000,000 dollar valuation. In 90 seconds, explain to a co-founder roughly how much ownership those SAFEs will convert into and why the cap matters so much here. The AI will play your co-founder, who says: but we never set a price, so how can they take that much?
Try it in real life
This week, pick one company you follow and find one real world example of safes, notes & convertibles. Write down what you noticed in two sentences.
Wrap up this lesson
Submitting the Quick Check counts. Or mark it here when you feel ready.