Convertible Notes for
Startups: A Safe
Alternative to the SAFE?
The Dilution, the Debt Maturity, and the
Distressed Startup
This Lesson: Convertible Notes Explained
For the files and resources, please go to:
https://breakingintowallstreet.com/kb/ventur
e-capital/convertible-notes/
(Excerpt from our VC & Growth Equity
Course.)
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This Lesson: Convertible vs. SAFE Notes
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This Lesson: Convertible Notes Explained
We previously covered SAFE Notes in this
channel (introduced by Y Combinator in
2013), a popular method for funding
early-stage startups.
But there is another alternative to priced
equity rounds: convertible notes.
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This Lesson: Convertible Notes Explained
These are NOT “convertible bonds” for
public companies – see our separate
convertible bond tutorial.
These are convertible notes for startups,
which are closer to SAFE Notes but with
slightly different mechanics / nuances.
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Convertible Notes in Short
• BASIC CONCEPT: With a Convertible Note, the startup gets
cash but does not get diluted upfront (no new shares) and
does not set a specific valuation in the round
• BUT: Unlike the SAFE, a Convertible Note has interest (usually
accrued to the principal, i.e., PIK Interest) and a maturity date
• SO: The Convertible Note is true “Debt,” with a clear spot in
the capital structure; the potential dilution is also higher
• WHY: Because the Convertible Note balance increases over
time, the investors get more shares upon conversion
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SAFE Notes vs. Convertible Notes
Defers Valuation &
New Shares
Faster/Cheaper than
Traditional Equity
Valuation Caps
and/or Discounts
Interest Rate and
Maturity Date
Conversion Triggers Next Priced Round Next Priced Round, but other triggers are possible
Repaid in Early Exit If possible, yes, but full repayment is less likely than with a
If possible, yes; depends on the exit price
Pre-Conversion Convertible Note
Repaid in Company Full repayment unlikely; partial repayment possible depending
Highly unlikely
Shutdown/Failure on liquidation proceeds
Dilution Potential Higher than Priced VC Rounds due to “Bargain” Purchase Price Higher than SAFE due to Accrued Interest
Use Cases Most common for speculative Seed Rounds Seed Rounds + “bridge loans” between Priced Rounds
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Convertible Notes: Lesson Overview
• Part 1: Convertible Notes in a Seed Round 5:19
• Part 2: Conversions in the Series A with an Options Pool 6:01
• Part 3: Side-by-Side: Convertible Note vs. SAFE 11:41
• Part 4: Should a Startup Use Either One of These? 12:35
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Part 1: Convertible Notes in a Seed Round
• Cap Table: Nothing changes! The co-founders and employees
have their shares and options, and that’s it
• Seed Investors: Do not get any shares in this round, even
though they’ve invested $2M in the company
• Valuation Cap: Tells you the maximum valuation they can get
shares at in the next priced round
• Conversion Discount: Tells you the discount to the share price
they can get their shares at in the next priced round
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Part 2: Conversions in the Series A Round
• Scenario: The startup raises $5M at a $10M pre-money
valuation, so the VC firm expects to own ~33% ($5 / $15)
• Step 1: Calculate the “Price per Share” in this Series A, based
on the Pre-Money Valuation / Pre-Money Shares
• Step 2: Determine the “Price per Share” that the Convertible
Note investors get (MIN between Cap and Discount prices)
• Step 3: Calculate each group’s New Shares in this round and
valuation of those shares (remember that the accrued interest
increases the Convertible Note principal!)
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Part 2: Conversions in the Series A Round
• Step 4: For the Options Pool, take the Total NON-OPTION
Shares, divide by (1 – New Option Pool Size %), and grant New
Options based on the Total Shares * Option Pool Size %
• Meaning: The employees get free (potential) shares in the
company, which dilutes the Seed and Series A investors
• Step 5: Link everything into the post-Series A Cap Table and
calculate the ownership percentages
• Results: The Series A investors do not own ~33%; they own
only ~24%!
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Part 2: Conversions in the Series A Round
• Why: Because the Seed Investors got their shares in this
round, so the “real” Pre-Money Valuation was higher!
• Solutions: There are different ways to grant shares to the Seed
Investors, such as methods based on weighted averages or
“Dollars Invested” instead
• Dollars Invested: Effectively, you reduce the Pre-Money
Valuation by the value of the Convertible Note, based on the
Cap or Discount (or something close to it)
• So: The Series A Investors end up owning more
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Part 3: Side-by-Side Comparison
• MAIN DIFFERENCE: If you consider only the conversion in the
Series A round, the Convertible Note creates more dilution
• BUT: This doesn’t tell the whole story because the Convertible
Note has other advantages over the SAFE
• EX: In a liquidation or company shut-down, the treatment is
much clearer (Debt, so it’s senior to all the Equity investors)
• Also: Convertible Notes have more varied use cases and can
sometimes act as “bridge loans,” while the SAFE is mostly for
Seed Rounds
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Part 4: Is Either One Worth It?
• My Opinion: I don’t think so, because most of their
advantages vs. priced equity rounds have diminished
• Investors: Convertible Notes favor the investors more than the
SAFE because of the maturity / full repayment required,
conversion triggers, accrued interest, and seniority
• “Bridge Loan”: Venture debt is more appropriate in between
priced rounds because it creates almost no dilution
• Seed Rounds: Can easily do a simple priced equity round
these days for little additional time/money
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Recap and Summary
• Part 1: Convertible Notes in a Seed Round
• Part 2: Conversions in the Series A with an Options Pool
• Part 3: Side-by-Side: Convertible Note vs. SAFE
• Part 4: Should a Startup Use Either One of These?
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