Strategic Early-Stage Financing: Navigating SAFEs and Convertible Notes

November 22, 2025

For early-stage founders and investors attempting to structure investment in an early stage (pre-seed) company, the choice between a Simple Agreement for Future Equity (SAFE) and a Convertible Note significantly impacts the capitalization table and future governance. Here are the key takeaways:

Efficiency Over Precision: Non-priced rounds allow companies to raise capital efficiently without the legal cost or complexity of prematurely attempting to establish a pre-money valuation. Generally, an early-stage company valuation is going to be relatively lower than when it attempts to sell equity to professional investors – the company valuation will generally increase over time if all is well with the venture.
Risk Reward: Both instruments utilize valuation caps and discounts to compensate early investors for betting on the company before proven traction.
Structural Differences: Convertible notes are debt instruments with interest and maturity dates; SAFEs are contractual rights to future equity, traditionally without debt features..
Liquidation Nuance: Generally, a convertible note will be pay the investor as a creditor in a liquidation event and a SAFE will not. Meanwhile, recent legal developments (specifically the 2025 In re Rhodium Encore decision) demonstrate that specific drafting choices in SAFEs can trigger creditor-like treatment in a liquidation (in this case, a bankruptcy).
Compliance: Regardless of the instrument, company issuers must comply with U.S. securities laws for private offering, typically utilizing Regulation D exemptions from registering the offering with the SEC.

Why Non-Priced Rounds Rule the Pre-Seed Stage

At the “friends and family” or pre-seed stage, the administrative burden of a priced equity round often outweighs the benefits finding that the “juice may not be worth the squeeze”.

Cost vs. Scale: A fully priced preferred stock round requires extensive negotiation, documentation, and legal costs that often exceed the scale of early raises.
Valuation Deferral: Early-stage companies often lack the metrics (revenue, user density) required to support an otherwise defensible valuation that wouldn’t wipe out the company founders. SAFEs and Notes allow parties to essentially “kick the can,” on pre-money valuation and detailed investment terms, letting professional institutional investors set the price in a future Series A round.
Speed to Close: These standardized instruments allow founders to close investment quickly, even on a rolling basis, rather than coordinating a single closing date for all parties.

Rewarding Early Risk: Discounts and Caps

Since early investors are not receiving a fixed number of shares immediately, they are reasonably due a premium for making an early stage investment. If they invest early, they should not pay the same price per share as later investors who enter after the risk has decreased.

The Discount: This provision gives early investors the right to convert their money into equity at a price lower than the Series A investors (typically ~20% off).
The Valuation Cap: This is the most critical economic term. It sets a maximum valuation at which the investment will convert in the future investment round.
- Example: If an investor holds a SAFE with a $5M cap, and the startup raises a priced round at a $10M pre-money valuation, the early investor converts as if the company were only worth $5M. This effectively grants them twice as many shares per dollar as the new investors.

Both mechanisms ensure that early backers “roll” into the professionally led round with terms that reflect a reward for the risk they took at the outset, and the benefit of participating in the preferences, safeguards and return mechanisms that will typically be featured in the future round.

Deep-Dive – How do they Differ?

A) SAFEs (Simple Agreement for Future Equity)

Introduced by Y Combinator, the SAFE is now ubiquitous in seed-stage deals. It is designed to look like equity while functioning technically as a contract for future shares.

Mechanics: SAFEs do not carry an interest rate and do not have a maturity date. They remain outstanding until a specific triggering event occurs-usually a “Qualified Financing” (a priced round raising a minimum amount) or a liquidity event (sale of the company).
Pre-Money vs. Post-Money: Founders must understand the distinction. The current standard “Post-Money SAFE” locks in the investor’s ownership percentage immediately, meaning the founders take the dilution impact of subsequent SAFEs, not the investors.
Pros/Cons: The primary advantage is simplicity and the removal of “ticking clocks” (maturity dates) and accruing interest that will further dilute the founders if converted to equity. The key disadvantage is that without a maturity date, investors have no enforcement mechanism if the company delays fundraising indefinitely or liquidates with the liquidated value being paid first to creditors.

B) Convertible Notes

The Convertible Note is the traditional precursor to the SAFE. It is legally a loan (a debt obligation) that effectively “disappears” by converting the principal and accrued interest into equity.

Interest: Notes accrue interest (typically 6-8% annually). This interest does not get paid in cash; instead, it adds to the principal balance and converts into more equity, slightly increasing dilution for founders.
Maturity Date: Notes have a deadline (usually 12-24 months). If the startup has not raised a priced round by this date, the investor can theoretically demand repayment or force a conversion at their own discretion.
Creditor Status: Because it is debt, noteholders rank senior to equity holders (founders) in a liquidation scenario. This offers downside protection for convertible debt investors.

Critical Caveats

For Convertible Notes: Maturity Alignment

A maturity date essentially creates a “cliff.” If you set a 12-month maturity but your runway to Series A is 18 months, you risk default. Founders should negotiate maturity dates that provide ample buffer (18-24 months) to avoid the pressure of renegotiation or forced conversion at unfavorable terms.

For Both Instruments: a “Qualified Financing” Threshold: The conversion is usually triggered by a “Qualified Financing”-defined as a round raising a specific amount of new capital (e.g., $1M-$2M).

Risk: If the threshold is set too high, a smaller bridge round won’t trigger conversion, leaving the notes/SAFEs outstanding and complicating the cap table.
Fix: Ensure the threshold and timing align with realistic fundraising targets for your next stage.

Finally – Some Insight on SAFE Liquidation

The treatment of SAFEs in a liquidation remains a bit nebulous for investors. Under industry standard SAFE terms, it is likely to be treated as contractual obligation that hasn’t been triggered.

A common conception is that SAFEs are generally treated as equity and provide investors with no distinct priority over the equity holders. However, the 2025 bankruptcy case In re Rhodium Encore LLC clarified that drafting can create and dictate priority in a liquidation.

In that case, the court found that SAFE holders were entitled to be treated as general unsecured creditors-ahead of common stock-because the SAFE contained a specific “Cash-Out Amount” provision.

The “Cash-Out” Trap

If a SAFE explicitly promises a payment upon a liquidity or dissolution event, bankruptcy courts may view it as a “claim” (debt) rather than an equity interest.

The Rhodium Ruling: The court held that the specific cash-out right in the Rhodium SAFEs created a “claim” under the Bankruptcy Code, placing SAFE holders ahead of stockholders in a liquidation.
Operative Language: The decision turned on the language of the SAFE Agreement, stating the company “will pay the Investor an amount equal to the greater of: (i) the investor’s Purchase Amount (the ‘Cash-Out Amount’); or (2)the amount payable to stockholders. The court relied on this structure to conclude the SAFE granted a “contingent right to payment”.

Drafting Educational Sample

To understand the distinction, compare the following logic found in liquidation provisions:

Drafting for Creditor Priority (The “Claim” Approach):

“In a Liquidity Event, the Investor shall receive the greater of (i) the Purchase Amount (the ‘Cash-Out Amount’) or (ii) the amount payable on the number of shares of Common Stock…”.

Implication: As seen in Rhodium, this creates a contingent right to payment, potentially elevating the investor above founders in a bankruptcy and guaranteeing that available proceeds will at a minimum be used to pay back the investor.

Drafting for Equity Alignment:

This approach eliminates the use of the term “Cash-Out Amount” to prevent any implication of predetermined or guaranteed payouts. Instead, it explicitly links distributions to each holder’s pro-rata portion of the assets available for distribution to common stockholders, promoting equal treatment of the investor and equity holders on a proportionate basis.

Takeaways:

Founders seeking to minimize liabilities should avoid fixed cash-out rights.
Investors seeking downside protection should ensure the “Cash-Out” language is explicit.

Choosing the Right Vehicle and Practical Checklists

While both instruments achieve the same primary goal: delaying both a premature valuation and an inefficient equity issuance, they serve different strategic needs. The choice generally comes down to a trade-off between Company Control and Investor Protection, as illustrated by the comparison table below.

The SAFE: Favoring the Company

SAFEs are widely considered “founder-friendly” because they strip away the punitive mechanics of debt.

Why Founders Prefer It: They remove the “Sword of Damocles” associated with maturity dates. There is no risk of defaulting on a SAFE, and there is no interest accumulating on the balance sheet. This simplicity allows founders to focus entirely on growth rather than servicing liabilities or renegotiating deadlines.
Best For: Pre-seed or “friends and family” rounds, smaller raises (under $1M), and accelerators where speed and cost-efficiency are paramount.

Convertible Debt: Favoring the Investor

Convertible Notes lean in favor of the investor by retaining the legal rights of a lender.

Why Investors Prefer It: A note provides a “belt and suspenders” approach to risk. If the company fails to raise a subsequent round, the maturity date forces the company to the negotiating table, giving the investor leverage to demand repayment or a conversion. Furthermore, if the company liquidates, noteholders are creditors who get paid before SAFE holders (unless drafted otherwise) and common stockholders.
Best For: Bridge rounds between priced equity events, larger seed raises, or risk-averse investors who require the structural safeguards of debt.

Side-by-Side Comparison

Feature	Convertible Debt	SAFE
Discount	(+) Investor: Rewards early risk. (-) Company: Increases dilution.	(+) Both: Same mechanism, but no interest compounding.
Valuation Cap	(+) Investor: Caps conversion price. (-) Company: Limits future flexibility.	(+) Company: Post-money variants make dilution math clearer.
Maturity Date	(+) Investor: Forces action/repayment. (-) Company: Risk of default/pressure, contingent liability on the company books.	(+) Company: No deadline; “fire and forget.” (-) Investor: No mechanism to force an exit.
Interest	(+) Investor: Value accrues over time. (-) Company: Increases dilution complexity.	(+) Company: No interest; cleaner cap table.
Liquidation	Senior Priority: Debt holders are paid before equity.	Ambiguous: Depends on drafting (see Rhodium Encore above).
Accounting	Liability: Sits on balance sheet as debt.	Equity/Derivative: Generally cleaner optics.

A Partial Checklist for Founders

Runway Reality: Does the Maturity Date (if using Notes) exceed your expected time needed to raise a preferred equity round (e.g., a Series Seed or Series A)?
Dilution Modeling: Have you calculated the impact of the Valuation Cap + Discount + Interest? (Post-money SAFEs can be deceptively dilutive if stacked).
Liquidation Review: Does your SAFE promise a “Cash-Out Amount”? If so, understand that this is likely a liability in a wind-down scenario.

A Partial Checklist for Investors

Downside Priority: If things go poorly, do you want creditor status (convertible note) or equity-like treatment (SAFE)? Confirm how the SAFE handles “dissolution” or “liquidity” events.
Maturity & Interest: Notes accrue interest and have a maturity date (leverage and a backstop, but also refinancing risk). SAFEs have no interest and no maturity (less leverage, simpler admin).
Pro-Rata / Follow-On Rights: Neither a standard SAFE nor a standard note guarantees pro-rata participation in company equity issuances, sales or future investments taken by the company prior to the Qualified Financing. Adding a side letter that grants a clear right to maintain your percentage, specifying post-money basis, allocation mechanics, and transferability can address this deficiency.
Investor Protections & Information Rights: Notes commonly include basic covenants and consent rights; SAFEs are lighter. If using a SAFE, consider adding information rights (e.g., quarterly updates, annual financials) at minimum.

A Final Consideration for Both Approaches Compliance Snapshot: Regulation D

Regardless of whether you issue a convertible note or a SAFE, U.S. federal law classifies these instruments as securities. To avoid the heavy burden of a public offering, issuers typically rely on Regulation D exemptions (Rule 506(b) or 506(c)), relying on these safe harbors from registration. In order for these safe harbors to apply, the company must comply with the following:

Accredited Investors Only: You generally must ensure investors meet income or net worth standards (accredited investor status). Many early-stage issuers limit rounds to accredited investors (under 506(b) or 506(c)) to avoid the added disclosure, cost, and timing complexity that comes with including non-accredited purchasers.
Form D Filing: The company must file Form D with the SEC within 15 days of the first sale of securities.
No General Solicitation: Unless specifically complying with Rule 506(c), founders cannot publicly advertise the fundraising (e.g., no social media blasts asking for funding).

Closing

The “best” instrument depends on the specific context of the raise. For early traction rounds, SAFEs offer efficiency and the least level of complexity. For bridge or larger rounds, or in cases where the investor requires additional downside protection, convertible debt is often the better choice.

While standard templates exist, the nuances of liquidation priority and dilution mechanics specifically require attention. By aligning the instrument with your company’s growth trajectory, you optimize for future success while mitigating legal pitfalls.

For more information about early-stage venture financing, or to talk about your startup needs, Contact Ted Theofrastous (TCT@kjk.com) or Cynthia Saad (CSaad@kjk.com).