A Founder's Guide to Notes & SAFEs: Caps, Discounts & More
Raising early-stage funding? You’ll need to know the ins and outs of convertible notes and SAFEs. In this Dreamit Dose, Steve Barsh, Managing Partner at Dreamit, gives you his breakdown and tells you what issues to avoid on these early-stage financing instruments. This companion post will better explain startup funding by covering the interplay of SAFEs, convertible notes, terms, and equity. You’ll learn 6 key points to be prepared and ready the next time you’re structuring a convertible note or SAFE financing.
Be clear on the basic terms & key items of notes & SAFEs
Before we can start talking about how to set the terms, including cap, let’s quickly review some definitions related to convertible notes and SAFEs. Typically at the really early stages, instead of a priced equity round, most startups will raise their first round using a convertible note or SAFE -- Simple Agreement for Future Equity. Both notes and SAFEs are fairly easy instruments to put together, they both (kind of) defer the valuation discussion, and investors can lock in an investment more easily at an earlier stage and price.
A convertible note is a loan that typically converts into shares of preferred stock during your next equity financing. Convertible notes are debt financing and have an interest rate and a maturity date -- just like the loan on your house or car.
A SAFE is not debt financing so it does NOT have an interest rate nor a maturity date.
Convertible notes and SAFEs can both be structured with a discount that rewards early investors for taking a really big risk. The discount gives them the right to convert their investment at a reduced price to what’s paid by the next round’s equity investors. For example, if the price per share of your next round comes in at $1, with a 20% discount, early investors will buy their shares for 80 cents. In essence, early investors’ cash will buy more shares when (and if) the next round occurs.
If this is a convertible note, as we mentioned, there is an interest rate on that note. Typical interest rates are 2-8% and that interest is “paid” during the future note conversation. One other big item for notes is the maturity date which is the date the note is “due and payable” if it has not already been converted.
Know about caps and how they work
So now that we’ve gotten the basic definitions out of the way, let’s start hitting what investors are usually most interested in hearing about - your cap. The conversion valuation cap (or “cap”) is a different mechanism that can be used to reward early investors for the risk they take and hopefully efforts they make to help increase the value of the startup.
The cap places a ceiling on the startup’s value in the next round. So if you go past the cap in your next round, your initial investors get to purchase at a lower price. They’re “protected” by the cap and compensated for taking early risk.
Understand the interplay of discounts and caps
The discount is a percentage off in the next round while the cap places a max ceiling on the valuation of the next round. When that next round occurs, early investors do not get both a discount and extra shares if the cap is exceeded. It’s one or the other, not both. We hear founders say “I did a SAFE and inventors get a 20% discount and a $7m cap”. They think their early investors will get both. That’s not the way it works. For the discount and cap, it’s an OR, not an AND.
Be aware of the challenges of an uncapped note
Here’s how Steve thinks about uncapped notes for the vast majority of cases. Early investors want to take risk and help startups, but they need to show strong overall returns. So if the value of a startup they make an initial investment into later starts to “run away” with an extremely high valuation, that will water down their investment if there is no cap. Therefore, many, if not most, sophisticated investors won’t put themselves into a situation to take the risk on an uncapped investment. Instead, they’ll just take a “wait and see” approach until the next priced round and if things are going well, and the valuation makes sense to them, buy-in foregoing the discount.
Sophisticated investors will argue that an uncapped note or SAFE misaligns founder and investor interests. Why? Because the lack of a cap waters down their investment, therefore, penalizing early investors for helping a startup increase in value. So smart investors will almost never take a no cap deal. An elegant and relatively simple solution is to cap the valuation into which the SAFE or note convert. As long as the next round is priced higher than the cap, both founders and seed investors are aligned and want the valuation as high as possible.
Caps won’t defer your valuation discussion
Let’s address how you actually set the cap. You have an idea, a super early product, and no real traction. And you feel it’s hard to figure out what your startup is really worth. Most founders know notes and SAFEs are faster, easier, and think they will “defer the valuation discussion.” The cap is often a negotiated estimate of existing company value and is based, most importantly, on what investors and the startup are willing to agree to. So your cap is actually set at fair market value. There really is no full deferral of the valuation discussion when using a cap.
Sometimes caps may not apply
While Steve encourages putting a cap on these instruments, there are three distinct situations a cap may legitimately not apply.
Serial entrepreneurs with incredibly strong previous successes are raising a round. Investors are worried about getting money into the company and are willing to put money in with no cap because they are trying to get a “foot in the door.” Since there is FOMO and incredibly strong demand, these particular founders can largely dictate terms that include no cap.
You’ve already raised, things are going fairly well, and you need a bit more runway to get your next equity round closed. That may call for a small convertible note bridge round with existing investors and do that with a discount but without a cap. Why no cap? You don’t want a cap to unduly influence the next round’s valuation which may be in just a few months. So insider investors may forgo the cap in this type of small bridge.
A fundraise involving unsophisticated angel investors or a “friends and family” round. You offer a note or SAFE with a 15-20% discount. Everyone is excited, they haven’t done a lot of angel investing before, don’t have a lot of experience with startups, and you may well be able to take their money and not give a cap.
A common “tell” that you are dealing with unsophisticated angel investors will be you repeatedly being asked the question -- “what’s your exit strategy?”
