Convertible Notes and SAFEs: Caps, Discounts, and the Dilution Math Founders Miss

Convertible instruments let a startup raise money before agreeing on a valuation. They are quick and cheap to paper, which is why almost every pre-seed round now uses them. The cost shows up later, at the first priced round, when the cap table reveals how much of the company the early money actually bought. This guide works through that math so there are no surprises.

Notes versus SAFEs in 2026

Carta's pre-seed data showed convertible notes at a record low 7% of pre-seed rounds and 8% of pre-seed dollars in Q1 2026; SAFEs accounted for almost all the rest, and most SAFEs now use a post-money cap. Notes are still common in capital-intensive fields such as biotech, medical devices, and energy, where investors want the protections of debt.

Worked example: a note converting

An illustration:

• $500,000 note, 6% simple interest, $6 million pre-money cap, 20% discount
• Series A 18 months later at $15 million pre-money, $2.00 per share
• Conversion amount with interest: $500,000 x (1 + 6% x 1.5) = $545,000
• Cap price: $2.00 x ($6M / $15M) = $0.80
• Discount price: $2.00 x 80% = $1.60
• The note converts at the lower price, $0.80, into 681,250 shares

The liquidation preference problem

If those 681,250 shares are ordinary Series A preferred, each carries the Series A's $2.00 liquidation preference. The noteholder's preference is then about $1.36 million on a $545,000 conversion amount, 2.5 times what they put in. In a modest sale, that preference comes ahead of common shareholders, including founders and employees.

The common fix is to convert notes and SAFEs into a sub-series of preferred (for example Series A-1) with a liquidation preference equal to the conversion price, or to issue a mix of preferred and common. Negotiate this in the Series A documents.

Worked example: stacked post-money SAFEs

Post-money SAFEs make each investor's ownership clear, and that clarity hides how quickly SAFEs add up for founders. An illustration:

• First SAFE: $500,000 at a $5 million post-money cap = 10%
• Second SAFE a year later: $1 million at a $10 million post-money cap = 10%
• Before the Series A, SAFE holders own 20% and the existing holders, mainly founders and the option pool, own 80%. The second SAFE did not dilute the first; it diluted the founders.
• Series A: $5 million at $20 million pre-money = 20% of the company after the round.
• After the Series A, founders and the existing pool hold about 64%, SAFE holders 16%, and the Series A investors 20%, before any option pool increase the new investors require.

An option pool top-up demanded by Series A investors usually comes out of the pre-money valuation, which dilutes founders further. Model your cap table after every SAFE, not only at the priced round. Medians from Carta's 2026 data put pre-seed SAFE caps from around $10 million for the smallest rounds to $30 million or more for rounds of $2.5 million and up, with AI companies commanding much higher caps.

Key terms and what to negotiate

• Valuation cap. The main economic term. A very high cap feels good but can create pressure to raise the priced round above it; a priced round below the cap is not a disaster for SAFE holders but signals weakness.
• Discount. Commonly 20% when included. Many post-money SAFEs are cap-only.
• Most favored nation (MFN). Gives early investors the better terms of later SAFEs. Useful for uncapped early money; it can complicate later rounds.
• Pro rata rights. The right to invest in the next round. The YC form handles this in a side letter.
• Interest and maturity (notes). At maturity, a noteholder can in principle demand repayment. In practice most extend or convert, but maturity gives them bargaining power if the company is struggling. Specify what happens at maturity, such as conversion at the cap, in the note.
• Change of control. What the holder gets if the company is sold before converting, usually the greater of their money back or the as-converted value.

Legal and accounting points

• Securities law. Notes and SAFEs are securities. Most rounds rely on Regulation D Rule 506(b), which requires a Form D filing within 15 days of the first sale and state notice filings. Raising from non-accredited investors has extra requirements; Regulation Crowdfunding allows up to $5 million in 12 months through a registered portal.
• Accounting. Many SAFEs are classified as liabilities under ASC 480 rather than equity, and notes are debt. This matters for audited financial statements and lender covenants.
• Taxes. For the Section 1202 qualified small business stock exclusion, a note's holding period generally starts at conversion. Whether a SAFE's holding period can start at signing is unsettled. For stock issued after July 4, 2025, the exclusion is 50%, 75%, or 100% after three, four, or five years, so the start date affects how much of a gain is excluded. Get tax advice before relying on either view.

Choosing an instrument

• Pre-seed with a few angels or accelerators: standard post-money SAFE, cap only, same terms for everyone.
• Bridge between priced rounds: a note or SAFE with a discount to the next round, often with the lead investor from the last round.
• Hardware, biotech, or long timelines: notes remain common, since investors want maturity and creditor protections.
• Once you have traction and a lead investor: a priced seed round gives clarity on ownership and governance, at higher legal cost.

For funding alternatives, see our guides to venture debt, revenue-based financing, and venture capital. If you are on the other side of the table, our angel investor guide covers evaluating these instruments as an investor.

Before you sign

1. Decide how much to raise to reach the milestones that justify a priced round, plus a buffer.
2. Model ownership after this round and after a hypothetical Series A, including an option pool top-up.
3. Use standard documents where possible; custom terms cost legal fees now and negotiation later.
4. Offer consistent terms within a round, or use MFN deliberately.
5. Plan the conversion mechanics, including a sub-series of preferred, before negotiating the Series A.
6. File Form D and state notices on time.

This guide is for informational purposes only and does not constitute legal, tax, or investment advice. Startup financing involves securities, tax, and accounting rules; work with experienced startup counsel and an accountant.