Convertible Notes and SAFEs: Fast Money, Hidden Costs

Startups raising initial capital often face an inherent challenge: They need funds to move forward, but they do not yet have the traction to support a valuation. Convertible notes and Simple Agreements for Future Equity (SAFEs) offer fast, flexible solutions. Investors put in money now, and the investment converts into equity later, usually during the next financing round.

 

Short, standardized agreements that do not require setting a price per share, SAFEs and convertible notes are especially popular in pre-seed and seed funding stages. That simplicity, however, can be deceptive. The terms of a SAFE or a convertible note can carry long-term consequences, especially when founders do not fully understand how they will affect the capitalization table at conversion.

 

The third article in Legal Basics for Startups: A Practical Series for Founders describes how these instruments work. It highlights common misunderstandings and provides guidance for efficient use.

 

Why Founders Use SAFEs and Convertible Notes

SAFEs and convertible notes allow startups to raise capital while postponing valuation until the company is more established. Instead of negotiating a price per share today, investors agree to receive equity later. The catch: The equity comes at a discount or is subject to a valuation cap.

 

Founders are drawn to them because:

• No valuation needs to be set.
• Legal costs and timelines are lower.
• Documents are short and require limited negotiation.

 

SAFEs, in particular, have become the default and are widely used in early-stage financing deals, thanks to their simplicity and founder-friendly reputation. However, these instruments are not free of risk. Without proper modeling, founders may not realize how much equity they are promising and how much control they are giving up.

 

Valuation Caps, Discounts, and Conversion Triggers

The two most important concepts in convertible instruments are the valuation cap and the discount. Conversion triggers determine when the instruments convert to equity.

 

The valuation cap sets the maximum company valuation at which the investor’s money will convert into equity. If the next financing round is priced above the cap, the investor gets a better deal. For example, if an investor puts $100,000 under a SAFE with a $4 million cap and the next round is priced at $10 million pre-money valuation with a $1 per share price, the SAFE converts at $0.40 per share. The investor gets 250,000 shares instead of 100,000.

 

The discount gives investors a percentage reduction off the price paid by new investors, typically 10 percent to 25 percent. If a SAFE includes a 20 percent discount and the next round is priced at $1 per share, the SAFE converts at $0.80 per share. With a $100,000 investment, the investor gets 125,000 shares instead of 100,000.

 

Some instruments include both a cap and a discount, and the better deal is generally applied. Conversion typically ties to the company’s next equity financing that raises a minimum threshold amount. But founders should review these triggers closely, as they can cause dilution and affect control.

 

What Founders Often Miss: Cap Table Modeling

The biggest mistake founders make with these instruments is failing to model their impact on the cap table.

 

For example, if a founder raises $1 million through four SAFEs, each with different valuation caps and discounts, those SAFEs will convert at different effective share prices. SAFEs with lower caps or higher discounts will convert into more shares, increasing dilution. Founders may end up issuing more equity than expected, especially if multiple SAFEs convert simultaneously at favorable terms for investors.

 

Without careful planning, founders may undermine their ability to raise capital in future rounds, offer equity to key hires, or retain meaningful control. Cap table modeling helps forecast these impacts and provides direction before signing any funding deal.

 

In later rounds, investors may ask for a separate class of stock, often called “shadow preferred.” These shares mirror the economic terms of earlier preferred stock, like liquidation preferences and anti-dilution protection, but they exclude control rights such as board seats or veto powers. This preserves key governance arrangements while giving new investors the same financial upside.

 

If founders convert early SAFE holders into the main preferred class instead of a shadow class, they might unintentionally grant those investors more influence than expected. Early convertible terms do not just cause dilution; they shape who has a say in the company’s future.

 

Common Mistakes and How to Avoid Them

Other common missteps include:

• Stacking SAFEs with different terms that create tension during conversion
• Failing to define triggering events clearly
• Relying on SAFE templates without tailoring them

 

Even if a SAFE or note seems “standard,” its effect on ownership can be anything but. Legal counsel can help harmonize terms, avoid conversion disputes, and avoid misalignment between early investors and future rounds.

 

When to Use Convertible Instruments

Generally, convertible notes and SAFEs work best when:

• The company needs to move quickly to secure funding.
• The valuation is difficult to determine.
• The amounts raised are relatively small or come from friendly investors.

 

But they should be used with caution when:

• The company expects multiple funding rounds with varied terms.
• The instruments are being layered without a plan for conversion.
• Founders are nearing a priced round and need clarity on the cap table.

 

A rule of thumb: If you are unsure how the instrument would affect ownership, stop. It might be wise to seek legal advice before moving forward.

 

From Simplicity to Strategy

Convertible notes and SAFEs are powerful tools, but they are not risk-free shortcuts. Their simplicity can obscure complex consequences for ownership and control. Founders who treat them lightly may find themselves surprised when those “simple” documents reshape the startup’s cap table.

 

Founders should understand how these instruments work and model their outcomes. The terms founders accept today will shape their stake in the company tomorrow.

 

Reach out to Nyemaster’s business team for help navigating startup decisions confidently to build long-term success.

 

For more insight into common issues for startups, other articles in this series  discuss key components for success :

• Avoiding Common Legal Pitfalls for Startups: Lessons from the Trenches
• The Founder’s Equity Dilemma: Vesting, Dead Equity, and Cap Table Health
• Picking the Right Legal Structure for Your Startup
• A Startup’s Introduction to Trademarks, Copyrights, Patents, and Trade Secrets
• Term Sheets Decoded: What Founders Should Know Before a Series A Funding

 

This article outlines general best practices and is provided for informational purposes only. It does not constitute legal advice or create an attorney-client relationship. Readers should seek legal counsel before taking action relating to the subject matter of this article. For more information, please visit our Terms of Use.