13: VC, Convertible Notes, and SAFEs

David LiuMay 28, 2025About 7 min

13: VC, Convertible Notes, and SAFEs

NOTE: If you encounter unfamiliar terms when reading the financial aspects of our case studies and related articles, there are useful glossaries of related terminology available at http://www.investopedia.com/dictionary/ and https://pitchbook.com/blog/private-equity-and-venture-capital-glossary and https://www.cooleygo.com/glossary/.

Read "What You Should Know About SAFEs". This article, published on the CooleyGO website, with its many embedded links, provides helpful information about Simple Agreements for Future Equity (SAFEs) as introduced in the above article on convertible notes. Cooley LLP is one of the top law firms dealing with startup ventures.

Read “Convertible Notes in Seed Financings”. This article expands on the topic of convertible notes which was introduced in the prior assigned reading, “Raising Startup Capital.” You may find it helpful to review this prior reading before reading today’s article.

As you read these articles, think how you would answer the following study questions:

What is a “priced round” of venture financing?
What is a convertible note? What are the fundamental differences between a convertible note and a priced round?
Compare and contrast a convertible note and a Simple Agreement for Future Equity (SAFE)?
What is the difference between a pre-money SAFE and a post-money SAFE?
Why is a convertible note advantageous to an investor? A SAFE?
Why is a convertible note advantageous to an entrepreneur? A SAFE?
What is the rationale for a “discount” in a convertible note? How does it work?
What is the nature of the divergent interests of the traditional convertible note investor and the entrepreneur in the period prior to the Series A investment?
What is the rationale for a “valuation cap” in a convertible note or a SAFE? How does it work? In what circumstances is a cap favorable for the investor, and in what circumstances is it favorable for the entrepreneur?
What additional terms are typically included in a convertible note transaction?
Why would a sophisticated investor, one with significant experience in evaluating and investing in early stage ventures, prefer a priced round over a convertible note or SAFE?

OPTIONAL: If you are particularly interested in the current startup funding environment, review the report, "State of Private Markets: Q4 and 2024 in review" from Carta. Carta is the leading platform that helps people manage equity, build businesses, and invest in the companies of tomorrow. Because it manages the cap tables for many early stage companies, Carta is in a unique position to capture data about the terms and nature of early stage investments. If you are interested in such data, Carta is a good source. However, in class, we will share data from PitchBook, which is a more comprehensive data source for startup fund-raising.

DUE:

There will be a short 12-minute closed-book, closed-notes quiz on one or more of today’s readings at the beginning of class. The quiz will be available via Canvas, so be sure to bring a laptop or tablet to class to take the quiz. Make sure your laptop/iPad is configured for Respondus Lockdown Browser.

Quiz questions are typically derived from the study questions provided above as part of the day’s assignment. While the quiz question may not exactly duplicate a study question, it usually will relate to the substance of one or more of the study questions. To prepare for a closed-book quiz, be sure you are prepared to address each of the posted study questions.

NOTE: Days on which we have quizzes, no essays will be due.

1. What is a “priced round” of venture financing?

A priced round is an equity financing in which the company and the new investors explicitly agree on a valuation for the company before the investment closes. This valuation determines the price per share of stock that the investor buys. For example, if an investor pays $4 million for 40% of the company, the post-money valuation is $10 million, implying a $6 million pre-money valuation plus $4 million of new capital. In a priced round, ownership percentages and share prices are locked in at the time of investment.

2. What is a convertible note? What are the fundamental differences between a convertible note and a priced round?

A convertible note is a short-term debt instrument that converts into equity upon a future financing round (or other specified triggering event) rather than granting equity at the time of the note’s issuance. Typical features include:

An interest rate (accrues over the life of the note).
A maturity date (when the note becomes due if a priced equity round or other trigger has not occurred).
A discount or valuation cap (or both) to reward seed investors for their early risk.

In contrast, a priced round involves setting the equity’s valuation (and thus its price per share) immediately. This requires lengthier negotiation and due diligence but gives investors a precise ownership stake right away. A convertible note defers that pricing decision to the next major round (usually a Series A), at which time the principal and accrued interest convert into equity—usually at a discount to reward the early investor’s risk.

3. Compare and contrast a convertible note and a Simple Agreement for Future Equity (SAFE).

Legal Form
- Convertible Note: Treated as debt. It accrues interest, carries a maturity date, and can, in principle, default if the company cannot repay it when due.
- SAFE: Equity-like contract, not debt. It does not have interest or a maturity date, so it cannot come due and force the company into default.
Conversion Mechanics
- Both: Convert into equity in the next priced round, typically at a discount or subject to a valuation cap.
- Convertible Note: The noteholders often receive the same class of preferred stock as the Series A, but their liquidation preference can “step up” to the discounted share price. This sometimes gives noteholders a liquidation preference above 1x their original investment, which is more generous to the investor.
- SAFE: Upon converting, the SAFE typically receives its own series of preferred stock—often called “Safe Preferred”—identical in rights to the new round’s preferred stock except for having a liquidation preference equal to the investor’s actual cash investment (rather than a “stepped-up” figure).
Upside vs. Simplicity
- Convertible Note: Potentially more negotiation around interest rates and the maturity date.
- SAFE: Typically simpler legal documentation (often standardized forms), no interest, no default risk.

4. What is the difference between a pre-money SAFE and a post-money SAFE?

Pre-Money SAFE: The valuation cap and resulting price calculations exclude the money coming in from the SAFE itself (and possibly other SAFEs) when determining the company’s “pre-money” valuation. This can be more favorable to the founders, since existing SAFEs convert alongside the new round and dilute each other.
Post-Money SAFE: The SAFE money (and possibly other SAFEs) is included when calculating how many shares are outstanding prior to the next investor’s purchase. This structure can be clearer for new (later) investors because it spells out exactly how much ownership is left for them, but it can lead to more dilution for founders and earlier SAFE holders.

5. Why is a convertible note advantageous to an investor? A SAFE?

Convertible Note – Advantages to the Investor

Priority in Downside Scenario: Because notes are technically debt, noteholders can have superior rights (e.g., if there is a liquidation before conversion).
Potential for Accrued Interest: The investor’s principal effectively grows until it converts.
Leverage at Maturity: The note can come due if no qualified financing occurs, giving some negotiating leverage.

SAFE – Advantages to the Investor

Simplicity: Fewer moving parts (no maturity date, no interest rate).
Potentially Entrepreneur-Friendly = More Deal Flow: Many startups prefer SAFEs for speed and simplicity, so an investor comfortable with SAFEs might access more early deals.

6. Why is a convertible note advantageous to an entrepreneur? A SAFE?

Convertible Note – Advantages to the Entrepreneur

Faster, cheaper closings: Less negotiation than a full priced round, so lower legal costs and quicker turnaround.
Defers Valuation: If the company grows significantly before the priced round, founders can sell equity at a higher valuation later, reducing founder dilution.

SAFE – Advantages to the Entrepreneur

No Repayment/Maturity Date: No risk of default if a future round or exit takes longer than expected.
Simplicity & Lower Legal Costs: Standardized SAFE documents (like Y Combinator’s versions) can reduce legal expenses and speed up the financing process.

7. What is the rationale for a “discount” in a convertible note? How does it work?

A discount compensates early investors for the risk they take by investing before the company has proven milestones. Upon the next round of financing, the note converts at a share price that is discounted (often 10–25%) relative to the new investors’ price. For example, if the new investors’ Series A price is $1.00/share and the discount is 20%, then the convertible note converts at $0.80/share. This ensures that those early investors get more shares for the same cash and are rewarded for stepping in earlier.

8. What is the nature of the divergent interests of the traditional convertible note investor and the entrepreneur in the period prior to the Series A investment?

Divergent interests arise because:

From the entrepreneur’s perspective, higher valuation at the next round is desirable—it reduces overall dilution.
From the noteholder’s perspective, if the valuation skyrockets (e.g., well above any discount-based benefit), the noteholder’s discount alone may not adequately compensate for the substantial risk they took. In other words, a bigger jump in valuation can leave noteholders with fewer shares, despite having invested at a very early (riskier) stage.

This tension often leads investors to insist on a valuation cap so that they do not get diluted too severely if the company’s next round is priced very high.

9. What is the rationale for a “valuation cap” in a convertible note or a SAFE? How does it work? In what circumstances is a cap favorable for the investor, and in what circumstances is it favorable for the entrepreneur?

Rationale: A valuation cap sets a maximum price at which the note or SAFE will convert, preventing excessive dilution of the early investor if the next round’s valuation is very high. The investor typically converts at the lower of:
1. A discounted share price, or
2. The share price implied by the valuation cap.
How It Works: If the uncapped valuation at the next round is extremely high, the cap “kicks in,” letting the early investor effectively invest at a lower valuation—thus receiving more shares.
Favorable to the Investor: If the company’s valuation grows beyond the cap, they get to convert at a lower (capped) price, ending up with a larger ownership stake.
Favorable to the Entrepreneur: At modest valuations, the cap might not bind, so the cap does not dilute the founder’s ownership as much. Also, setting a moderately high cap can attract investors but still protect founder equity if the exit remains within certain ranges.

10. What additional terms are typically included in a convertible note transaction?

Besides discount and valuation caps, convertible notes often include:

Interest Rate: Typically 4–8% (sometimes as high as 14%, sometimes near 0%).
Maturity Date: Ranges from 12 to 24 months. If the note has not converted by then, investors can demand payment or renegotiate.
Conversion Threshold (Qualified Financing Size): Often a minimum raise (e.g., $2 million) must occur in the next round for automatic conversion.
Board/Information Rights: Some noteholders negotiate a board seat or certain information rights (though this is more common with larger checks).
Acquisition Premium: If the company is acquired before conversion, noteholders may receive an automatic multiple (e.g., 1.5x or 2x) of their principal.

11. Why would a sophisticated investor, one with significant experience in evaluating and investing in early stage ventures, prefer a priced round over a convertible note or SAFE?

Sophisticated investors sometimes favor a priced round because:

Certainty & Ownership: They lock in a specific price and ownership percentage immediately, rather than waiting for a future conversion event.
Standard VC Protections: Priced rounds typically come with negotiated investor rights, such as liquidation preferences, protective provisions, board seats, and anti-dilution protection, spelled out clearly at the time of the deal.
Less Hidden Dilution: In large or complex financings, multiple unpriced instruments (notes/SAFEs) can create confusion and unexpected dilution for all parties. A priced round brings clarity to the cap table.
Due Diligence: Sophisticated investors often want to carry out thorough diligence early. Since they are writing bigger checks, they see value in a full negotiation on valuation, founder vesting, governance, etc.