When a startup is raising its first round of outside capital — often called a seed round or pre-seed round — it rarely goes through the full term sheet negotiation and definitive document process associated with a priced equity round. Instead, most early-stage startups raise money using one of two simpler instruments: a convertible note or a Simple Agreement for Future Equity, universally called a SAFE. Both instruments allow investors to put money into the company now in exchange for equity later, typically at the time of a priced financing round. Understanding how each instrument works, what the key terms mean, and how they affect founders’ ownership and investors’ rights is essential knowledge for anyone raising early-stage capital.

What Is a Convertible Note?

A convertible note is a form of debt. When a startup issues a convertible note, it is borrowing money and promising to repay it — with interest — at a future date. The distinguishing feature of a convertible note is that the debt is designed to convert into equity rather than being repaid in cash. At the time of a qualifying financing event — typically when the company raises a priced equity round above a specified threshold — the outstanding principal and accrued interest on the convertible note convert into shares of the company at a price that reflects either a discount to the priced round price or a valuation cap, whichever is more favorable to the note holder.

The debt nature of convertible notes has several practical implications. Because the note is technically debt, it creates a maturity date — a date by which the debt is due and payable if the conversion event has not occurred. If the startup has not raised a qualifying financing round by the maturity date, the note holder may demand repayment of the principal and accrued interest. This creates a potential liquidity crisis for startups that miss their expected financing timeline. Founders should pay attention to maturity dates and should address them proactively with investors before they arrive, either through an extension of the maturity date or through negotiated conversion.

What Is a SAFE?

The Simple Agreement for Future Equity was created by Y Combinator, the prominent startup accelerator, as a simpler alternative to the convertible note. A SAFE is not debt. It is a contractual right to receive equity in a future financing round, structured so that the investor provides cash now and receives shares later when a qualifying financing event occurs. Unlike a convertible note, a SAFE has no maturity date, accrues no interest, and does not create any debt obligation for the company. This makes it significantly simpler than a convertible note from both a drafting and a balance sheet perspective.

Y Combinator publishes standardized SAFE templates that are widely used and well-understood by investors and lawyers in the venture ecosystem. The most common forms are the post-money SAFE and the pro-rata SAFE. The simplicity and standardization of the SAFE has made it the dominant instrument for early-stage seed financing in Silicon Valley and increasingly across the country.

Key Terms: Valuation Cap

The valuation cap is one of the most important economic terms in both convertible notes and SAFEs. The cap sets a maximum valuation at which the investor’s money converts into equity, regardless of the actual valuation of the company when the qualifying financing occurs. If the company raises a priced round at a valuation higher than the cap, the early investor converts at the cap — effectively at a lower price than the new investors pay — which results in more shares for the early investor.

For example, if an investor purchased a SAFE with a $5 million cap and the company later raises a Series A at a $20 million pre-money valuation, the SAFE investor converts as if the company were valued at $5 million, not $20 million. This means the SAFE investor receives four times as many shares as a Series A investor investing the same amount. The cap compensates early investors for the greater risk they took by investing before the company had established the milestones that justified the higher Series A valuation.

A lower cap is better for investors and more dilutive to founders. A higher cap is less dilutive to founders but less favorable to investors. Negotiating the cap requires founders to make a judgment about what the company will be worth at the time of its first priced round and to structure the cap accordingly.

Key Terms: Discount Rate

In addition to or instead of a valuation cap, convertible notes and SAFEs often include a discount rate. The discount rate gives the early investor the right to convert at a specified percentage below the price paid by investors in the qualifying financing round. A 20% discount means the early investor’s money converts at 80% of the price new investors pay, which results in more shares for the early investor compared to later-stage investors who pay full price.

Many instruments include both a valuation cap and a discount and convert using whichever method is more favorable to the investor. In practice, for companies that grow rapidly and raise their first priced round at a high valuation, the cap tends to be more favorable to the investor than the discount, because the cap effectively compresses a large valuation step-up into more shares. For companies that raise their priced round at a more modest valuation, the discount may provide more benefit.

Pre-Money vs Post-Money SAFEs: An Important Distinction

Y Combinator’s original SAFE form was a pre-money SAFE, which calculated the conversion percentage based on the company’s valuation before the qualifying financing. In 2018, Y Combinator revised its standard SAFE to a post-money form, which calculates the investor’s conversion percentage based on the post-money valuation — that is, the company’s capitalization after the SAFE investment. This distinction matters significantly for founders.

Under the pre-money SAFE, multiple SAFE investors investing at the same cap did not know with certainty how many shares they would receive at conversion because each SAFE diluted the others and the total dilution from all SAFEs was not fixed at the time of issuance. Under the post-money SAFE, each investor’s ownership percentage is determined at the time of investment: the investor owns a specified percentage of the company after the SAFE money is taken into account. This makes it easier for investors to understand their expected ownership and makes it easier for founders to model the cap table. However, for founders, post-money SAFEs can result in more dilution than pre-money SAFEs if many SAFEs are issued at the same cap, because the post-money calculation treats each SAFE as having a fixed ownership claim rather than sharing dilution proportionally.

Most Favored Nation Clauses and Pro Rata Rights

Some convertible notes and SAFEs include a most favored nation clause, which requires the company to offer existing SAFE or note holders the benefit of any more favorable terms given to future investors in subsequent rounds before the conversion event. An MFN clause protects early investors against the company raising money from later investors on better terms — a lower cap, a higher discount, additional rights — without extending those terms to existing holders.

Pro rata rights give SAFE or note holders the right to invest in the qualifying financing round at the same price as the new investors, up to a specified amount. This right allows early investors to maintain their ownership percentage in the company as it grows rather than being diluted by each successive financing round. Pro rata rights are common in SAFE and note agreements and are generally not controversial, but founders should understand that they can reduce the amount of the financing round available to new investors and can complicate the allocation of the round if many early investors exercise their pro rata rights.

Choosing Between Convertible Notes and SAFEs

For most early-stage US startups today, the SAFE is the simpler and more founder-friendly instrument. It has no maturity date, no interest accrual, and standardized terms that are well understood by investors in the startup ecosystem. The simplicity of the SAFE also reduces legal costs: a well-understood, standardized document requires less legal review time on both sides.

Convertible notes remain common in some contexts. Some investors, particularly outside the Bay Area ecosystem, are more familiar with and prefer convertible notes. Investors who are regulated entities — family offices, some institutional investors — may prefer debt instruments for accounting or regulatory reasons. In jurisdictions outside the US, the SAFE may not be as well understood, and a convertible note may be a more recognized structure.

Before issuing either instrument, founders should understand the capitalization implications by modeling out what happens to the cap table at conversion under various scenarios, the total amount of dilution from all outstanding SAFEs or notes, and the potential effects on founders’ ownership percentage. This analysis, conducted with the help of a startup lawyer, is essential for making informed financing decisions and for negotiating terms that reflect the company’s actual trajectory and valuation expectations.