Understanding SAFEs and Convertible Notes for Startups

Part 1: Instruments of Innovation — and Future Complexity

When founders raise their first capital, it is often through instruments designed for speed and simplicity. SAFEs and convertible notes emerged to avoid the lengthy negotiations of priced equity rounds, allowing startups to access capital fast and defer valuation discussions. These instruments are essential tools for early-stage financing, but they are not without cost. They introduce ambiguity, build overhang, and create latent dilution.

Understanding how SAFEs, convertible notes, and equity function is not just about legal mechanics. It is about cap table evolution. Each instrument affects ownership, control, and financial modeling in different ways. And if not carefully tracked and modeled, they can compound into surprises at the most inopportune moments — like during a priced round or exit.

As a CFO, your job is to ensure these tools are wielded wisely. That means knowing how they convert, when they convert, and what happens to your cap table when they do.

Part 2: SAFEs — Simple Agreements with Non-Simple Outcomes

SAFEs (Simple Agreements for Future Equity) are not equity today, but a promise of equity tomorrow. Developed by Y Combinator in 2013, SAFEs allow investors to provide capital now in exchange for future shares, typically at a discount or valuation cap.

Key Characteristics:

• No maturity date
• No interest
• Convert upon priced equity round or liquidity event
• Often include valuation cap, discount, or both

Valuation Cap: Sets a maximum valuation at which the SAFE will convert. If your next round is priced above this cap, the SAFE holder converts at the lower valuation — gaining more shares.

Discount: Offers a percentage discount (typically 10 to 25 percent) on the next round’s share price. If the cap is not triggered, the discount provides the benefit.

Example:

• SAFE with $2 million investment
• Valuation cap: $10 million
• Discount: 20 percent
• Priced round at $20 million

The SAFE converts as if the valuation were $10 million (the cap), not $20 million. This effectively gives the SAFE investor twice as many shares as a new Series A investor.

Impact on Cap Table:

• Creates invisible dilution until conversion
• Converts before new investor ownership is calculated
• Often excluded from founder modeling

SAFEs are fast and founder-friendly in the moment, but they accumulate quietly. A cap table with five SAFEs can produce a conversion shock, leaving founders diluted more than expected. The smart CFO builds out conversion models long before the priced round.

Part 3: Convertible Notes — Debt That Acts Like Equity

Convertible notes are the predecessor to SAFEs. They function similarly in many respects but carry different legal and structural implications.

Key Characteristics:

• Legally a debt instrument
• Includes interest (typically 4 to 8 percent)
• Includes a maturity date (often 18–24 months)
• Convertible at a discount or valuation cap
• Can include repayment rights upon maturity

Example:

• $500,000 note
• 6 percent interest
• 20 percent discount
• $8 million valuation cap

At maturity or priced round, the noteholder receives shares based on the lower of the capped valuation or discounted price. If no priced round occurs before maturity, the note becomes due — creating potential liability.

Impact on Cap Table:

• Dilutive upon conversion, similar to SAFEs
• Accrues interest that increases converted amount
• Maturity date can trigger repayment pressure or forced negotiation

Convertible notes offer structure where SAFEs offer flexibility. But they also carry more risk for founders. If maturity arrives before a priced round, the startup could face a cash crunch or legal conflict.

A best-in-class CFO maintains a maturity table and models conversion scenarios well before notes become due. The key is not to be surprised by compounding interest or conversion triggers.

Part 4: Priced Equity — Clarity, Dilution, and Strategic Control

Priced equity rounds — such as Series Seed, A, or B — involve selling shares at a defined price. These rounds establish a formal valuation, update the company’s charter, and often include preferred stock with rights and preferences.

Key Characteristics:

• Establishes pre- and post-money valuation
• Issues preferred shares with liquidation preferences
• Typically includes investor rights, board seats, and protective provisions

Impact on Cap Table:

• Immediate and transparent dilution
• Converts outstanding SAFEs and notes
• Establishes baseline for future 409A valuation

Compared to SAFEs and notes, priced equity rounds provide clarity. They define who owns what, at what price, and under what governance structure. But they also formalize dilution. When SAFEs and notes convert, they increase the share count, often reducing founder ownership.

Here is a typical sequence of dilution:

• Pre-Seed SAFE: 10 percent (implied, converts in Series A)
• Seed Convertible Notes: 12 percent (implied)
• Series A: 20 percent
• Option pool refresh: 10 percent

Founders may believe they still own 60 percent — until the SAFEs and notes convert. Suddenly, that number drops to 40 percent or lower. That is not a negotiating failure. It is a modeling failure.

Operationalizing the Transition

The transition from SAFEs/notes to equity must be carefully managed:

• Cap Table Preparedness: Maintain pro forma cap tables with full conversion modeling.
• Legal Review: Ensure all instruments are clean, documented, and convertible per the charter.
• Communication: Inform stakeholders — especially employees and advisors — of changes in share count and ownership.
• 409A Alignment: Update the 409A valuation post-pricing to reflect new fair market value.

Strategic Considerations for the CFO

1. Avoid Stack Bloat: Too many SAFEs or notes create a conversion overhang. Limit rounds or consolidate instruments if possible.
2. Cap and Discount Structure: Understand how combinations of cap and discount affect ownership. Model each instrument’s conversion path.
3. Timing of Conversion: Choose whether SAFEs convert pre- or post-money. This shifts the dilution burden significantly.
4. Investor Communication: Preemptively explain how prior instruments convert to new investors. Surprises lead to mistrust.
5. Exit Planning: Some SAFEs convert at acquisition, not funding. Know your instrument’s triggers.

Conclusion

Early capital is essential to growth, but its form determines your future structure. SAFEs and notes are efficient, but they defer dilution and governance. Equity rounds provide clarity but demand rigor. The operational CFO anticipates not just the capital needs of today, but the structural implications of how that capital converts.

A clean, modeled, and communicated cap table is a strategic asset. It builds investor trust, strengthens internal alignment, and avoids unpleasant surprises when it matters most — at your next round or your exit.

Disclaimer: This blog is for informational purposes only and does not constitute legal, financial, or investment advice. Please consult your professional advisors before making financing or cap table decisions.