PRE-SEED FINANCing GUIDE
A Founder-Friendly Guide to Convertible Notes, SAFEs, Side Letters, and Conversion Math
Author: Nicholas G. Bushelle, Attorney with Dentons’ Corporate Practice and Venture Technology and Emerging Growth Companies Group
Raising your first outside capital can feel like learning a new language while also trying to build a company. Pre-seed financing is often the first meaningful round of outside funding for a startup, and it usually comes before a company is ready for a full “priced round,” where investors buy preferred stock at an agreed company valuation. Early-stage companies commonly raise this money using convertible notes or SAFEs, which let founders bring in capital now and postpone the harder valuation conversation until a future equity financing. Pre-seed financing is more than a legal document exercise – founders are often making decisions in these early rounds that affect their ownership, investor relationships, and next fundraise. The goal of this guide is to make those decisions easier to understand before anyone signs.
What is pre-seed financing, and why does it matter?
Pre-seed financing is typically money raised very early in a company’s life to fund product development, customer discovery, hiring, launch costs, and basic operations. In many cases, the company is not yet far enough along for investors and founders to confidently agree on a fixed valuation, so they use instruments that convert into stock later.
That “convert later” feature is useful because it can let a founder close investments more quickly and avoid negotiating a full preferred stock financing when the business is still forming. But it also means the economic deal is not as simple as “we raised $500,000.” The conversion terms can determine how much of the company the investor eventually owns, what kind of stock the investor receives, and how much dilution the founders experience in the next round.
Convertible Notes vs. SAFEs
A convertible note is a loan that is expected to convert into equity later, usually when the company raises a qualifying priced equity round. It generally has a principal amount, an interest rate, a maturity date, and conversion terms such as a discount rate or valuation cap.
A SAFE, short for “Simple Agreement for Future Equity,” is not structured as traditional debt. It gives the investor a contractual right to receive stock in the future if a trigger event occurs, such as a priced equity financing, sale of the company, or dissolution.
The biggest practical difference is that SAFEs generally do not have interest or a maturity date. Convertible notes usually do. That matters because a note can create pressure as the maturity date approaches, while a SAFE can remain outstanding until a conversion or liquidity event occurs.
Founders often prefer SAFEs because they are shorter, standardized, do not accrue interest, and can be faster and less expensive to negotiate. Investors often prefer convertible notes because notes are debt instruments until conversion and may include investor protections that SAFEs do not provide by default. For example, a noteholder usually has a creditor claim for principal and accrued interest, while SAFE holders generally receive fewer rights until the SAFE converts.
Key terms found in both notes and safes
Two terms show up again and again in pre-seed financing conversations: the discount rate and the valuation cap.
A discount rate gives the early investor a reduced price compared with the price paid by new investors in the future priced round. For example, if the future Series A price is $1.00 per share and the SAFE has a 20% discount, the SAFE investor’s conversion price would be $0.80 per share.
A valuation cap sets a ceiling on the valuation used to calculate the investor’s conversion price. If the next round is priced above the cap, the investor converts as if the company were valued at the cap, which can give the investor more shares than a simple discount would.
When a note or SAFE has both a cap and a discount, the investor usually gets whichever calculation produces the lower conversion price, and therefore more shares. The investor does not usually get to stack both benefits; the investor gets the better of the two.
YC’s SAFE Templates: What Founders Should Know
Y Combinator, a prominent startup accelerator based in San Francisco, originally created the concept of a SAFE and still maintains and updates the industry-standard templates. YC’s current post-money SAFE materials describe several SAFE “flavors,” including a standard post-money valuation-cap SAFE, a discount-only SAFE, and an MFN-only SAFE. A valuation-cap SAFE uses a negotiated post-money valuation cap. A discount-only SAFE converts using a negotiated discount rate rather than a cap. An MFN-only SAFE has no valuation cap or discount at signing but may let the investor adopt more favorable terms from a later SAFE financing.
YC previously made a valuation-cap-and-discount SAFE available as an alternative version, but YC later removed that version from its website because YC’s recommendation was to use either the valuation-cap version or the discount version. In the market, however, many investors still ask for both a valuation cap and a discount.
If investors cannot get both, why do they often prefer a cap?
If an investor has to choose between a valuation cap and a plain discount, the investor may prefer a cap when they believe the startup’s valuation could increase quickly. The reason is simple: a cap can produce a much larger effective discount than a standard 20% discount if the next round’s valuation is far above the cap.
For example, if a company raises a venture round at a $10 million pre-money valuation but has convertible instruments with a $3 million cap, the noteholders effectively receive a 70% discount. That is dramatically more investor-favorable than a typical 15% to 25% note discount.
A low cap can transfer a meaningful amount of upside from founders to early investors if the company grows quickly before the priced round.
Side letters in VC pre-seed deals
A side letter is a short agreement that gives a specific investor extra rights outside the main SAFE or note. Pre-seed investors may negotiate side letters for rights such as pro rata rights, information rights, board observer rights, or most favored nation protections.
Pro rata rights let an investor buy more shares in a future financing to help maintain its ownership percentage. Information rights may require the company to provide financial statements, business updates, budgets, forecasts, or updated cap tables. Board observer rights may let an investor attend board meetings without voting. MFN rights may let an investor receive the benefit of more favorable economic terms later offered to another investor.
These rights can be appropriate for a meaningful lead investor, especially if that investor is writing a large check or bringing strategic value. But founders should be careful about granting too many rights to too many pre-seed investors. Founders should think carefully about pro rata rights because founders may later need to make room for new investors, existing investors with contractual pro rata rights, and sometimes existing investors without formal rights whom the company still wants to include. A broad group of pro rata holders can delay allocation decisions, cap table finalization, and closing of the next round.
A practical takeaway for founders is to avoid turning every small early check into a long-term administrative obligation. If a later institutional lead investor is trying to build a clean priced round, too many pre-seed side letters can create friction, and the new investor may ask the company to clean up, waive, or terminate earlier special rights as a condition to closing.
Conversion mechanics: Do the math before you sign
Conversion mechanics are the rules that determine how a SAFE or note turns into stock. This can sound technical, but the founder-friendly version is straightforward: the lower the conversion price, the more shares the investor receives, and the more dilution the founders and existing stockholders may experience.
Founders should ideally run cap table models before signing any convertible instrument. There are many different ways to calculate note and SAFE conversions, and convertible instruments do not always make the intended calculation clear.
Founders should also model the impact of the option pool because the treatment of the option pool can change who bears dilution. VC investors often require an option pool to be included in pre-money capitalization, which can increase dilution for founders.
Here are three simplified examples using a post-money SAFE with both a valuation cap and a discount rate. In each example, assume a $250,000 SAFE, a 20% discount, 10 million fully diluted pre-money shares before the financing (including converting SAFEs), and a future priced round where the SAFE converts into preferred stock. These examples use the common approach that the investor receives the better of the discount price or the cap price.
The discount wins. Assume the Series A pre-money valuation is $10 million, so the Series A price is $1.00 per share. The 20% discount price is $0.80 per share. If the SAFE has a $12 million valuation cap, the cap price is $1.20 per share. Because $0.80 is lower than $1.20, the discount applies, and the SAFE converts into 312,500 shares, calculated as $250,000 divided by $0.80.
The cap wins. Assume the Series A pre-money valuation is $20 million, so the Series A price is $2.00 per share. The 20% discount price is $1.60 per share. If the SAFE has an $8 million valuation cap, the cap price is $0.80 per share. Because $0.80 is lower than $1.60, the cap applies, and the SAFE converts into 312,500 shares, calculated as $250,000 divided by $0.80.
A high-growth scenario can make the cap much more valuable than the discount. Assume the Series A pre-money valuation is $40 million, so the Series A price is $4.00 per share. The 20% discount price is $3.20 per share. If the SAFE has an $8 million valuation cap, the cap price is $0.80 per share. The cap produces an 80% effective discount to the Series A price, so the SAFE converts into 312,500 shares instead of only 78,125 shares at the discounted $3.20 price.
These examples are simplified, but they show why the cap table model matters. Real financings may involve multiple SAFEs, different caps, convertible notes, accrued interest, option pool increases, pro rata rights, and new investor ownership targets.
Tax considerations: QSBS and SAFE treatment
Many founders and investors care about Qualified Small Business Stock, often called QSBS, because Section 1202 of the Internal Revenue Code can allow eligible holders of qualifying C corporation stock to exclude gain after satisfying certain requirements, including certain holding periods. For convertible notes, the holding period for Section 1202 purposes would not begin until after the note converts into shares of a C corporation.
SAFEs are more nuanced. YC’s SAFE form states that the parties intend the SAFE to be characterized as stock, and more particularly as common stock, for U.S. federal and state income tax purposes, including for Section 1202 purposes. SAFEs lack certain debt characteristics like interest and maturity, which makes them look more like equity. There is no direct IRS guidance that conclusively settles the tax classification of SAFEs, so founders should speak with a tax advisor before relying on SAFE issuance as the start of a QSBS holding period.
Convertible note templates: Less standard than SAFEs
One reason SAFEs became popular is that YC published standardized forms that many startups and investors recognize. Convertible notes are different – they do not have a single established template, which can make review more time-consuming and expensive.
That does not mean founders should start from scratch. The Angel Capital Association has published a model convertible promissory note intended to combine common note provisions with provisions often found in side letters or note purchase agreements, while balancing founder and investor interests. The ACA form also highlights common note terms such as a participation right, select information rights, an optional MFN provision, an optional board observer seat, and protective provisions for certain corporate actions while the notes are outstanding.
For founders, a good template is a starting point, not a substitute for understanding the deal. Notes can vary significantly with respect to interest, maturity, conversion triggers, caps, discounts, investor rights, default provisions, and amendment mechanics.
Four practical takeaways for first-time founders
Know what you are optimizing for. SAFEs may be faster and simpler, while notes may give investors more debt-like protections.
Model dilution before signing. A cap that feels harmless today can create a much larger investor ownership stake if your company grows quickly before the next round.
Be selective with side letters. Rights like pro rata, information rights, and board observer rights can be reasonable for important investors, but they can become hard to manage if granted broadly.
Remember that the document is only one part of the financing. A strong pre-seed round should support the company’s next milestone, preserve enough founder ownership to keep the team motivated, and avoid creating cleanup issues for the next round.
Pre-seed financing is supposed to help you move faster, not bury you in avoidable complexity. With the right modeling, the right advisors, and a clear understanding of the tradeoffs, founders can use SAFEs and convertible notes as practical tools for building momentum while keeping the next round in view.
Meet the author
Nick Bushelle is an attorney with Dentons’ Corporate practice and Venture Technology and Emerging Growth Companies group. He provides guidance to high-growth startups, funds, middle-market businesses, and public companies on venture financings, mergers and acquisitions, joint ventures, securities compliance, equity compensation, SaaS contracts, and other corporate transactions. He works with clients in a variety of industries, including agtech, biotech, fintech, insurtech, real estate, healthcare, senior housing, and manufacturing.
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