Increasingly, founders are turning to convertible instruments (40-95%, depending on round size) when raising the initial rounds of capital for their companies. These agreements allow deals to be struck without (directly) negotiating a valuation, expediting the process by setting aside key terms for the future.
There are two main categories of convertible instrument: SAFEs and Convertible Notes. The SAFE is a more recent creation, conceived by Carolynn Levy of Y Combinator in 2013, and has quickly become the default tool for very early rounds. It is generally what we would recommend to founders, with some exceptions which we will describe below.
A note on SAFEs vs Convertible Notes
The difference between SAFEs (Simple Agreement for Future Equity) and Convertible Notes (also called Convertible Debt, or Convertible Loan Agreements), is that SAFEs are a straightforward fundraising tool while Convertible Notes are a form of debt financing. Until the point that the Convertible Note is converted into equity, founders will typically have to pay interest on the capital. Additionally, there may be more complex rules about what constitutes a ‘qualified financing event’ to trigger the conversion, and it may contain a maturity date by which unconverted debt has to be repaid. In general, Convertible Notes are preferred in more capital and risk-intensive environments such as funding for medical devices, energy or pharma startups, or by more conservative investors.
The key components of convertible instruments
Despite the debt vs equity distinction, both operate on the same principle: they represent investment today, at an unspecified valuation, for the promise of equity at certain trigger events such as (qualified) priced rounds or acquisitions. In return for getting involved early, where risk is greater, these investors also get a pricing benefit at those conversion events — in the form of a cap or a discount.
What is a cap?
A valuation cap is a ceiling on the price at which the investment will convert to equity.
e.g. if you were to take a Pre-Seed investment via a SAFE with an $8M (post-money) cap, and then you went on to raise a Seed round at $12M pre, equity would be issued to SAFE holders based on the $8M cap.
What is a discount?
A valuation discount is a coefficient that is applied to the future priced round valuation.
e.g. if you were to take a Pre-Seed investment via a SAFE with a 20% discount, and then go on to raise your Seed round at $15M pre, the SAFE investment would convert to equity at $12M based on the discount.
The purpose of convertible instruments
Despite their promise of practicality, the aim to simplify the process can create confusion. Frequently, investors and founders aren’t sure which mechanism is appropriate, or how to determine the terms of the discount or cap. To explain this process, it’s important to understand the application of both:
Use a cap if you can forecast valuation
Valuation caps imply that both sides have a rough understanding of a number of factors, including when a priced round is likely to happen, and approximately at what value it is likely to take place. Setting a cap is effectively planting a flag in the future; a target price for that point in time.
This applies best to startups on a more predictable startup growth path, such as SaaS or consumer apps, where a cap can be determined more easily.
Use a discount to provide price flexibility
Valuation discounts, on the other hand, work on the assumption that you can’t easily predict anything about the future. You may not know when the priced round will be, or how much progress you will have made by that point. You are asking investors to wait and see what those terms look like.
As opposed to setting a cap, discounts are most appropriate for startups with front-loaded risk and uncertainty, such as hardware, biotech or deeptech.
Choose a cap, or a discount, not both
While about 30% of SAFEs include both a cap and a discount, to assure investors they will get favourable pricing at conversion, it doesn’t make a lot of practical sense. The two mechanisms address the risk of early investments from two different perspectives, and building in both mechanisms — so investors’ using whichever provides a ‘cheaper’ share price — feels punitive. Investors should want to ensure you have the best shot at success, especially if you’re struggling.
Emphasizing this point, Y Combinator offers SAFE templates with a cap, or with a discount, but not both.
“YC’s recommendation to founders was to issue either the valuation cap flavor safe or the discount flavor. We did not encounter situations where the combo safe was the preferred choice. Accordingly, we decided it was incongruous to make this version available.” – Y Combinator “Website User Guide”, 2023
A note on pre-money and post-money SAFEs
As well as caps or discounts, founders need to give careful consideration to whether their SAFE agreements are 'pre-money' or 'post-money'. The difference between the two is simply whether the cap or discount apply pre-money (before the SAFE capital is added) or post-money (after the SAFE capital is added. The latter is more ‘investor friendly’ because it guarantees a minimum equity percentage of your company when you raise a priced round, regardless of whatever happens between now and then — simplifying ownership calculations. If you end up having to raise a much larger priced round than anticipated, whether that's because things are going badly or going very well, you’ll therefore have to take more dilution from a post-money SAFE.
Choosing the appropriate mechanism
To start, we might consider caps as the default mechanism by merit of their popularity. If you fit into that category of well understood startups with mostly predictable risk, this direction may make sense. That decision covers two key points:
- The risk associated with your future is mostly market and performance related; are you going to live up to your growth expectations?
- There are no existential assumptions relating to the future of your startup, e.g. regulatory questions, clinical trials, technological readiness, manufacturing viability, etc.
Next you just have the problem of determining what the cap should look like. How do you accurately capture the value of your future?
Fortunately, for companies with less existential risk, a better understood market, and more obviously relevant comparable companies, you can project into the future with greater certainty. It becomes more reasonable to set a cap which reflects that future potential.
In the other case, perhaps you’re raising a convertible to finish the testing and development of a radical new hardware solution. How do you account for the extreme uncertainty of that circumstance? You might end up raising a huge priced round to fund production at scale, if everything goes according to plan. Alternatively, you might find the results aren’t quite as expected, and you need to make product changes or focus on a smaller part of the market.
This is where a discount becomes more appealing as a mechanism for price preference. Whatever the terms at the time the priced round is completed, the investors are rewarded for their risk and you aren’t over-diluted. In contrast to a cap, this approach allows you to entirely delay the pricing process until that future round occurs. The downside, for both sides, is that the ultimate ownership and dilution will be less clear at the outset — particularly in comparison to a post-money SAFE.
Why discounts have fallen out of favour
There is a major flaw with standard SAFE documents that use only a discount: the discount is fixed, and does not compound over time.
In practice, this means that there is no great pressure for founders to raise a priced round and convert those investors. They can wait as long as they want, and those early investors who took on the greatest level of risk with their capital slowly see their future returns erode as the company increases in value before they own actual equity.
Because of this, discount-only SAFEs have been less popular than versions packing both a cap and a discount — where the discount was just a sweetener if the priced round came in below the cap. That application has distorted the perception of discounts, with the median now just 20%, which is even less appealing to investors.
There are two sides to the solution:
- Discounts should compound over time, rewarding investors who invest when risk is highest, and encouraging founders to convert those investments to equity earlier.
- Discounts should be rooted in something tangible, so both sides of the transaction understand what it represents and why.
Setting the right terms
You want to set either or a cap or a discount that is based on some clear logic, which will be understood and appreciated by your investors. If you choose a cap, they should understand that it is modelled around the future ambition for your startup. If you choose a discount, they should understand the value of the flexibility and how it is modelled around their required investment return.
Setting your SAFE cap
Based on the logic of what a cap sets out to achieve, an appropriate solution is to use the top of your current valuation range as the cap. This way, you’re maintaining a coherent story with investors.
While investors may be skeptical valuations predicated on assumptions about the future at such an early stage, it’s an effective way to paint a picture of the future that can justify your cap. By the time you get to that priced round, you should have proven much of your initial pitch by hitting those milestones and building traction.
In the example below, we’ve used the valuation for a startup raising a $1.5M Pre-Seed SAFE round to determine the valuation cap that will be offered to investors, via the high bound of the valuation range provided by our methodology — though any similar approach which outputs a high bound would be appropriate.
| $1.5M Pre-Seed SAFE | Cap (High bound of weighted average) |
|---|
| Scorecard | Checklist | VC Method | DCF with LTG | DCF with Multiple |
|---|---|---|---|---|
| 30% | 30% | 16% | 12% | 12% |
| $6.36M | $5.75M | $6.26M | $4.93M | $21.66M |
| Low Bound | $6.47M |
| Weighted Average | $7.83M |
| High Bound (Cap) | $9.18M |
| Dilution | 16.34% |
To understand the low and high bound, we look at the variance between the different methods, and the 30th percentile and the 70th percentile on that curve.
Setting your SAFE discount
Given the role of a discount, you should consider the required ROI for venture capital when determining your discount. This way, you are appropriately compensating investors for the risk and opportunity cost of that capital.
By deferring valuation entirely until that subsequent priced round, and increasing the discount over time, early investors can be confident that whenever you raise the priced round, and at whatever price, they will get appropriately preferential pricing, reflecting the time they’ve had skin in the game that hadn’t yet converted to equity. While this results in a much greater discount than is commonly seen today, keep in mind that this is without a cap.
You can see in the examples below, using the required ROI of 89.12% for ‘Startup stage’ companies, how the discount affects conversion in the case of a startup raising their Series A after a SAFE Seed round of $3.5M:
| $3.5M Seed SAFE | Discount (Required ROI 89.12%) |
|---|
| Time to conversion | 18 Months | 21 Months | 24 Months |
| Total discount | 52.59% | 60.43% | 67.13% |
| Scenario: Median Series A ($45M Valuation) |
| Dilution | 20.23% | 23.65% | 27.78% |
| Adjusted price | $17.3M | $14.8M | $12.6M |
| Scenario: Outlier Series A ($75M Valuation) |
| Dilution | 12.15% | 14.23% | 17.24% |
| Adjusted price | $28.8M | $24.6M | $20.3M |
| Annual Discount: -47.03% |
To model these outcomes yourself, use the following fomula:
= priced round valuation / (( 1 + required ROI) ^ ( number of months * (1/12)))
Final thoughts on convertible instruments
Convertible instruments, especially SAFEs, make fundraising easier for very early stage companies. They’ve become a staple of venture capital, for that reason. However, there’s a very real danger that startups and investors are relying too much on these instruments without properly understanding their application and the long term implications. Whether it’s stacking too many SAFEs and producing nightmarish cap tables, or just failing to meaningfully price company equity, there are always downsides to a shortcut.
Convertibles should be seen as a tool to get to a priced round at such a point that the value of the startup can be better understood — not just a way to kick the can down the road. Especially when much of today’s popular wisdom around SAFEs is reflective of flawed averages or misuse. This does a real disservice to founders, especially in capital-intensive sectors like deeptech and biotech where there is significant sensitivity to dilution.
Venture capital is all about outliers. Exceptions. So we strongly advise founders (and investors) to take a first-principles approach to understanding and applying these instruments. Especially when it comes to understanding in what scenarios it makes sense to use post-money or pre-money price at conversion, exactly why you might use a discount or a cap, and how you determine the detail of those terms.