Fundraising Instruments Deep Dive

Understanding how different financing instruments work is essential for founders choosing the right structure and for agents explaining fundraising mechanics. This slice provides detailed mechanics for SAFEs, convertible notes, and priced rounds—the three primary instruments used in startup fundraising. Each has distinct conversion mechanisms, terms, and trade-offs.

For universal fundraising concepts (stages, investor types, dilution basics), see Startup Fundraising Primer. For US-specific instrument details, see US Fundraising Primer.

SAFE (Simple Agreement for Future Equity)

SAFEs are contracts that convert to equity in a future priced round. They're not debt—no interest, no maturity date, no repayment obligation. SAFEs were created by Y Combinator to simplify seed-stage fundraising and have become the dominant instrument for pre-seed and seed rounds in the US.

Conversion triggers: SAFEs convert automatically when the company raises a priced round (typically Series A). They also convert on acquisition or IPO. Some SAFEs include valuation caps or discounts that affect conversion price. Once converted, SAFE holders become shareholders with the same rights as other investors in that round.

Valuation cap sets a maximum pre-money valuation for conversion calculation. If a SAFE has a $5M valuation cap and the company raises Series A at $10M pre-money, the SAFE converts as if the round was at $5M pre-money, giving SAFE holders more shares. The cap protects early investors from dilution if the company raises later at much higher valuations. Caps range widely—$2M-$15M for pre-seed SAFEs, $5M-$30M for seed SAFEs, depending on company traction and market conditions.

Discount rate gives SAFE holders a percentage discount off the priced round's price per share. A 20% discount means if Series A investors pay $1.00 per share, SAFE holders convert at $0.80 per share. Discounts typically range from 10% to 25%, with 20% being common. Discounts compensate early investors for taking risk before the company's value is established.

Most Favored Nation (MFN) clause protects SAFE holders if the company issues SAFEs to later investors with better terms. If you invested with a $5M cap and the company later offers a $3M cap, the MFN clause lets you adopt the better terms. MFN clauses are common in early SAFEs to protect against terms getting better as the company gains traction.

Post-money SAFEs calculate ownership percentage based on post-money valuation, making dilution more transparent. Traditional SAFEs (pre-money) calculate ownership at conversion, which can be unclear until conversion happens. Post-money SAFEs specify ownership immediately—"invest $100K for 2% ownership" means the company's post-money valuation is effectively $5M, regardless of what the future priced round valuation is.

Conversion mechanics: When a priced round occurs, all SAFEs convert simultaneously. If a SAFE has both a cap and a discount, it uses whichever provides more favorable conversion (typically the cap at early stages, discount at later stages with higher valuations). The conversion increases the company's share count, diluting existing shareholders.

When to use SAFEs: Ideal for pre-seed and seed rounds when companies want to raise quickly with minimal legal complexity. SAFEs are faster and cheaper than priced rounds, don't require company valuation negotiation, and defer dilution calculation until a priced round. They work well when companies anticipate a priced round within 12-24 months.

Convertible Notes

Convertible notes are debt instruments that convert to equity in a future priced round. Unlike SAFEs, they have interest rates, maturity dates, and can theoretically require repayment if not converted (though conversion is almost always the intent).

Principal and interest: Convertible notes have a principal amount (the investment) and an interest rate (typically 4-8% annually). Interest accrues and converts with principal, not paid in cash. A $100K note with 6% interest over 2 years converts as $112K ($100K principal + $12K interest). The interest compensates investors for the time value of money while waiting for conversion.

Maturity date is when the note is due if not converted. Typical maturities are 18-24 months. If the company hasn't raised a priced round by maturity, the note can be extended, converted at maturity valuation, or (rarely) require repayment. In practice, maturity dates create urgency for the company to raise a priced round. Extension agreements are common if the company needs more time.

Valuation cap works similarly to SAFE caps—it sets a maximum pre-money valuation for conversion. A $5M cap means the note converts as if the priced round was at $5M pre-money, even if the actual round is higher. Caps protect early investors from dilution if valuations increase significantly.

Discount rate functions like SAFE discounts—investors get a percentage off the priced round's price per share. Typical discounts are 15-25%. Discounts are often combined with caps—the investor uses whichever provides more favorable conversion.

Conversion triggers: Convertible notes convert automatically on priced rounds (typically Series A), acquisition, or IPO. Some notes include optional conversion rights at maturity or upon certain events. Conversion mechanics mirror SAFEs—principal plus accrued interest converts based on cap or discount terms.

When to use convertible notes: Convertible notes are traditional debt instruments, making them familiar to some investors and potentially easier for companies with existing debt structures. They're less common in US seed funding today (SAFEs dominate), but remain common in UK/EU markets. Convertible notes may be preferred when companies want to structure as debt for accounting or tax reasons, or when dealing with investors more comfortable with traditional debt instruments.

Priced Rounds

Priced rounds involve selling equity at a fixed price per share, creating immediate ownership and valuation. Priced rounds are standard for Series A and beyond, though some companies do priced seed rounds.

Share price calculation: Price per share equals pre-money valuation divided by fully-diluted outstanding shares. If pre-money is $10M and there are 10M shares outstanding, share price is $1.00. New investors pay this price per share. If they invest $5M, they receive 5M shares (20% ownership, making post-money $15M).

Fully-diluted shares include all outstanding shares plus reserved option pools. This matters because option pool creation dilutes existing shareholders. If a company has 8M outstanding shares and creates a 2M share option pool before the round, fully-diluted is 10M shares, which determines share price. This is why option pool size is negotiated as part of valuation.

Share classes: Priced rounds typically create a new share class (Series A Preferred, Series B Preferred, etc.). Preferred shares have different rights than common stock—liquidation preferences, dividend rights, voting rights, conversion rights. Preferred shareholders get paid first in exits before common shareholders.

Investor rights: Priced rounds establish investor rights through multiple legal documents: purchase agreements (terms of sale), investor rights agreements (ongoing rights like information rights, pro-rata rights), voting agreements (board seats, major decision rights), and right of first refusal agreements (preventing unauthorized transfers). These rights provide investors with ongoing influence and protection.

Board seats: Priced rounds often include board seat provisions. A Series A investor might get a board seat, changing board composition and decision-making dynamics. Board control matters for major decisions—hiring/firing CEO, raising future rounds, major pivots, acquisitions, and exits.

Closing mechanics: Priced rounds typically close in one or multiple tranches. All investors sign the same documents and convert/fund simultaneously. The closing process involves legal documentation (2-4 weeks typically), investor signatures, wire transfers, and share issuance. The company receives funds at closing.

Post-closing: After closing, investors become shareholders with rights and responsibilities. They receive regular updates, board materials, and financial reports. They participate in major decisions and can exercise pro-rata rights in future rounds. The relationship is ongoing, not transactional like SAFE conversion.

When to use priced rounds: Required for institutional investors who can't invest in debt instruments or need board seats and investor rights. Standard for Series A and beyond. Priced rounds provide clarity on valuation and ownership, establish investor relationships, and create governance structures. They're more expensive and time-consuming than SAFEs but necessary for institutional capital.

Comparison and Decision Framework

SAFE vs Convertible Note vs Priced Round: The choice depends on stage, investor type, speed needs, and complexity tolerance.

Speed and cost: SAFEs are fastest and cheapest—minimal legal documentation, no valuation negotiation, no board seats. Convertible notes are similar but slightly more complex due to interest and maturity terms. Priced rounds are slowest and most expensive—extensive legal documentation, valuation negotiation, investor rights agreements, 6-12 weeks typical timeline.

Valuation clarity: Priced rounds provide immediate valuation clarity—everyone knows the company is worth $X pre-money. SAFEs and convertible notes defer valuation until conversion, which creates uncertainty about dilution but also flexibility.

Investor preferences: Some investors prefer certain instruments. Institutional VCs typically require priced rounds—they can't invest in debt instruments, need board seats, and require investor rights agreements. Angels and seed funds are comfortable with SAFEs. International investors may prefer convertible notes (common in UK/EU).

Conversion dynamics: SAFEs and convertible notes both convert in priced rounds, but they convert based on different terms. SAFEs with caps convert based on cap or discount; convertible notes include interest in conversion. Priced rounds create immediate ownership—no future conversion needed.

Dilution timing: SAFEs and convertible notes defer dilution until conversion, which can create surprises at conversion time (all SAFEs convert simultaneously, potentially significant dilution). Priced rounds show dilution immediately, making cap table impact clear upfront.

Recommendation framework: Use SAFEs for pre-seed and seed when speed and simplicity matter, investors are angels or seed funds, and a priced round is anticipated within 12-24 months. Use convertible notes when dealing with investors who prefer debt structures or in markets where notes are standard. Use priced rounds when raising from institutional VCs, need board seats and investor rights, or want immediate valuation clarity.

The instrument choice affects fundraising strategy, investor relationships, and company governance. Understanding these trade-offs helps founders choose the right structure for their situation.