In Article 1, we examined the structural differences between SAFEs and convertible notes—maturity, interest, leverage, and how these instruments behave when timelines shift.
This article turns to what most founders and investors focus on first: valuation caps and discounts. These terms appear straightforward. In practice, they are the primary drivers of dilution and often the least carefully modeled component of early-stage financing.
Caps and discounts are not simply pricing tools. They are allocation mechanisms. Understanding how they function—and how they interact with one another—is critical before issuing multiple instruments.
The Basic Framework
Both SAFEs and convertible notes typically convert into equity in a future priced financing. The price at which they convert is determined by either:
- A valuation cap
- A discount
- Or whichever produces a more favorable result for the investor
The mechanics are simple in concept:
- A valuation cap sets a maximum company valuation at which the instrument converts.
- A discount provides a percentage reduction from the price paid by new investors in the priced round.
Most instruments provide for conversion at the lower price implied by either the cap or the discount.
While that seems mechanical, the implications depend heavily on timing, stacking, and cap table composition.
Valuation Caps: What They Actually Do
A valuation cap is not the company’s valuation. It is a pricing mechanism that rewards early capital.
If a company issues a SAFE with a $5 million valuation cap and later raises a priced round at a $15 million pre-money valuation, the SAFE converts as though the company were valued at $5 million (subject to the instrument’s specific definitions).
In effect, the early investor receives a lower conversion price and therefore more shares for the same dollar invested.
Two issues commonly arise:
- Pre-money vs. post-money definitions
Modern SAFE forms distinguish between pre-money and post-money valuation caps. The difference materially affects dilution calculations, particularly when multiple SAFEs are outstanding. The economic outcome can vary significantly depending on the drafting. - Stacking at different caps
Companies often issue SAFEs over time at increasing caps. When the priced round occurs, each tranche converts at its own cap. The cumulative effect can substantially reduce founder ownership before the new investors’ equity is even issued.
The cap determines who absorbs that dilution. It is rarely intuitive without modeling.
Discounts: A Secondary Lever
A discount typically provides that the instrument converts at a percentage reduction—often 10% to 25%—from the price paid by new investors in the next round.
For example, with a 20% discount, if Series A investors pay $1.00 per share, the SAFE or note converts at $0.80 per share.
Discounts matter most when:
- The next round valuation is modest relative to expectations.
- The valuation cap is set high enough that the discount produces a better conversion price.
In many financings, the valuation cap drives the economics and the discount is largely irrelevant. In others—particularly where caps are set aggressively high—the discount becomes the operative term.
Investors often focus on securing both. Founders often underestimate which will control.
Multiple Instruments: Where Complexity Emerges
The complications begin when more than one instrument exists.
Consider a company that issues:
- $500,000 at a $4 million cap
- $750,000 at a $6 million cap
- $1 million at a $10 million cap
If the company raises a priced round at a $12 million pre-money valuation, each tranche converts differently. The earliest investors receive the most favorable pricing. Later investors receive progressively less favorable pricing.
Before the new Series A shares are even issued, founder ownership may be reduced significantly.
Add to that:
- Accrued interest on notes
- Option pool increases required by new investors
- Pre-money versus post-money SAFE mechanics
The resulting cap table can differ meaningfully from initial expectations.
This is not a drafting issue. It is a modeling issue.
The Option Pool Interaction
In many venture financings, investors require an option pool increase to be implemented prior to the closing of the priced round.
If early instruments convert before or after that pool expansion—and depending on whether the valuation cap is defined on a pre- or post-money basis—the economic burden of that pool expansion shifts.
In some structures, founders absorb nearly all of the dilution associated with both the early instruments and the option pool increase.
The language governing capitalization definitions, “Company Capitalization,” and “Fully Diluted Basis” becomes central.
These definitions often receive less scrutiny than headline cap numbers, but they control outcome.
The Psychological Anchor Problem
Valuation caps frequently become psychological anchors. Founders may view a $10 million cap as validation of company value. It is not.
A cap is an incentive mechanism to compensate early investors for risk. It does not establish fair market value. Nor does it dictate the pricing of the next round.
Problems arise when:
- Early caps are set too low relative to expected growth.
- Subsequent investors demand caps that exceed realistic valuation progression.
- Founders delay a priced round to avoid triggering conversion.
Inconsistent cap progression can create tension in later negotiations, particularly when institutional investors review prior issuances.
Early financing should anticipate the valuation narrative the company expects to present in its next round.
Convertible Notes: Additional Considerations
When dealing with convertible notes rather than SAFEs, two additional elements affect conversion economics:
- Interest Accrual
Accrued interest increases the conversion amount. Even modest interest over an extended period can increase dilution in aggregate. - Maturity Renegotiation
If maturity approaches without a qualified financing, amendments may include revised caps or discounts. These renegotiations often occur under leverage pressure.
Thus, while caps and discounts define baseline economics, maturity and interest can shift those economics over time.
Strategic Observations
From a company perspective:
- Caps should be modeled across realistic fundraising scenarios.
- Multiple issuances should be consolidated into a pro forma capitalization analysis.
- Post-money SAFE mechanics should be understood before layering additional instruments.
- The anticipated Series A structure should inform early drafting decisions.
From an investor perspective:
- A cap that appears attractive in isolation may be diluted by later issuances at lower caps.
- Discount-only structures may provide limited protection if valuations escalate sharply.
- Conversion priority and capitalization definitions materially affect outcome.
The central discipline is forward modeling, not term sheet comparison.
Practical Discipline Before Issuance
Before issuing any SAFE or convertible note, companies should be able to answer:
- What does founder ownership look like after conversion at three different valuation scenarios?
- How will an option pool increase interact with outstanding instruments?
- Are we using pre-money or post-money cap definitions?
- How much aggregate dilution could occur before the priced round investors receive their shares?
These questions are not theoretical. They determine long-term ownership control.
Looking Ahead
Article 1 addressed structural differences between SAFEs and convertible notes. This article has examined valuation caps and discounts—the economic core of these instruments.
In Article 3, we will examine how SAFEs and convertible notes affect control, governance dynamics, and acquisition negotiations—particularly in transactions where a priced round never occurs.
Early instruments are simple on their face. Their downstream consequences are not.