The Complete Guide to Convertible Instruments in Venture

· 21 min read
venture-capital startups finance

Convertible instruments are everywhere in startup financing, but I’ve found that a surprising number of people (including founders who have signed them) don’t fully understand the mechanics. When I was Head of Data Science at Aumni, we had visibility into thousands of these instruments across the venture ecosystem, and the data told a consistently clear story about how they’re structured, how they’ve evolved, and where things go wrong. This post is my attempt to put all of that into one place: what convertible notes and SAFEs actually are, how valuation caps work, why bridge rounds after a Series A look different from early-stage convertibles, and what happens when these instruments hang around longer than anyone planned for.

This post is for informational and educational purposes only. Nothing here is legal, tax, or investment advice. Consult qualified professionals before making any decisions based on this content.

Part 1: How Convertible Notes Work

The Basics

A convertible note is, at its core, a loan. The company borrows money from an investor, and instead of repaying the loan with cash, the debt converts into equity at some future point, typically when the company raises a priced round of financing. It’s a way for early-stage startups to raise capital without having to negotiate a valuation upfront, which is often a sticking point when a company is too young to have meaningful revenue or traction metrics.

The appeal for founders is speed and simplicity. You don’t need to negotiate a full term sheet with a price per share, a board seat, protective provisions, and all the other machinery that comes with a priced round. For investors, the note provides some downside protection (it is technically debt, after all) along with the upside of converting into equity at a discount.

Discount Rates

The discount rate is one of the primary incentives for investors to put money into a convertible note rather than waiting for the priced round. It gives the note holder the right to convert their debt into equity at a price lower than what new investors pay in the next round.

Here’s how it works in practice. Say a startup raises its Series A at $2.00 per share. If an earlier investor holds a convertible note with a 20% discount, they convert at $1.60 per share instead. They get more shares for the same dollar amount, which compensates them for the risk they took by investing before the company had established its price.

Most convertible notes carry a 20% discount. This has been remarkably consistent over the years. You’ll occasionally see discounts as low as 10% or as high as 30%, but 20% is the center of gravity. It’s become the default that both sides expect, one of those things in venture where convention has basically hardened into a standard.

Often lawyers will quote these as discount rates not discounts, saying “80% discount rate” rather than “20% discount”. This confuses me regularly, and may also confuse you, so always clarify.

Interest Rates

This is the part that sometimes surprises people. Even though convertible notes are designed to convert into equity, they’re still debt instruments and they accrue interest. That interest doesn’t get paid out in cash. Instead, it adds to the principal amount that converts into equity, so the investor ends up with slightly more shares when conversion happens.

Interest rates on convertible notes tend to mirror broader economic conditions, tracking closely with the Fed’s rate cycle, on a lag. When the cost of capital goes up everywhere, convertible note rates follow.

The interest component might seem like a small detail, but it matters when a note stays outstanding for a long time. If a note has an 8% interest rate and sits unconverted for 18 months, that’s 12% additional principal that converts into equity. For a company that’s slow to raise its next round, the interest can add meaningful dilution.

Maturity Dates

Every convertible note has a maturity date, the deadline by which the note either converts or has to be repaid. In theory, if the company hasn’t raised a qualifying round by the maturity date, the investor can demand repayment of the principal plus accrued interest.

In practice, enforcing repayment against a cash-strapped startup would usually just force the company into a bad position. Most of the time, if a maturity date arrives and the company hasn’t raised yet, the note holder and the company negotiate an extension. But the maturity date still serves an important function. It creates a forcing mechanism, giving investors leverage to push for a resolution (whether that’s a priced round, an acquisition, or a wind-down) rather than letting the company limp along indefinitely.

How Conversion Works

The conversion event is the whole point of the instrument. When the company raises a qualifying priced round (typically defined by a minimum funding amount specified in the note), the outstanding principal plus accrued interest automatically converts into shares of the new preferred stock at whichever price is more favorable to the investor: the discount to the round price, or the price implied by the valuation cap.

There’s an important nuance here. The note holder gets the same class of stock as the new investors, with the same rights and protections. They don’t end up with some junior class of equity. This is actually one of the advantages of convertible notes over some other financing structures. When conversion happens, everyone ends up holding the same preferred shares, which simplifies the cap table.

Part 2: SAFEs and Valuation Caps

What SAFEs Are (and Aren’t)

A SAFE, or Simple Agreement for Future Equity, is Y Combinator’s alternative to the convertible note. It was introduced in 2013 as a way to make early-stage fundraising even simpler by stripping out the debt-like features of a convertible note. A SAFE has no interest rate, no maturity date, and isn’t technically debt. It’s an agreement that the investor will receive equity in a future priced round, subject to whatever terms are specified in the SAFE.

The conceptual difference matters more than most people realize. Because a SAFE isn’t debt, the investor can’t call it due. There’s no maturity date that creates urgency, no interest clock ticking in the background. The investor is making a bet on the company’s future, with the conversion mechanics defined upfront, but with no guaranteed timeline for when (or whether) that bet resolves. This makes SAFEs simpler and faster to execute, which is exactly why they took off so quickly at the earliest stages of venture financing. But it also means the investor has less structural leverage than they would with a convertible note, a tradeoff that matters more in some market environments than others.

For a few years, it looked like SAFEs were going to eat the world of convertible instruments. They were simpler, faster to close, and had the blessing of Y Combinator, which meant every accelerator-stage company was using them by default. But convertible notes never went away. When the market corrected sharply in 2022, the power dynamic shifted back toward investors, and the structural features that convertible notes offer started looking attractive again.

SAFEs continue to dominate in pre-seed and the earlier stages, with convertible notes being most common in later stage companies and larger deals.

Why Convertible Notes Regained Ground

Two things drove the shift. The first is investor risk appetite. In the bull market of 2020-2021, founders had leverage and pushed for the simplest possible terms. A SAFE with a valuation cap and nothing else was often enough to close a round. When the market shifted, investors started asking for more protection. Convertible notes offer interest accrual, maturity dates, and the legal standing of debt, which give investors more tools to manage risk in uncertain environments.

The second is the macro environment. With elevated rates through much of 2024, investors putting money into convertible notes were being compensated more for the time value of their capital. When risk-free rates are near zero, note interest feels like a rounding error. When they’re at 5%, it starts to matter.

Valuation Caps: The Core Mechanic

A valuation cap sets the maximum valuation at which a convertible instrument will convert into equity when the company raises a priced round. If a company raises its Series A at a $30M valuation but the SAFE has a $10M cap, the SAFE holder converts as if the valuation were $10M. They get three times as many shares as they would without the cap. It’s the primary mechanism that protects early investors from getting diluted into irrelevance when a company’s valuation takes off between the time they invested and the time they convert.

If the discount rate is the floor of investor protection, the valuation cap is the ceiling of founder dilution. In practice, the instrument converts at whichever mechanism gives the investor the better deal: the discount or the cap. Most of the time, when a company does well, the cap ends up being the operative term.

Valuation caps are generally considered an investor-friendly provision. Without a cap, a SAFE investor is essentially betting that whenever the company raises a priced round, the conversion economics will still make sense for them. With a cap, they have a floor on their ownership percentage regardless of how high the next-round valuation goes.

The Rise of Uncapped SAFEs

Between 2020 and 2024, the prevalence of pre-priced-round SAFEs issued without a valuation cap increased meaningfully. An uncapped SAFE is about as founder-friendly as a convertible instrument gets. The investor has no ceiling on the conversion price, which means in a strong market, they could end up with a much smaller ownership stake than they anticipated when they wrote the check.

I think the uptick reflects uncertainty in the valuation environment. Setting a valuation cap requires both parties to have at least a rough consensus on what the company is worth. When valuation benchmarks are stable, agreeing on a cap is relatively straightforward. But when valuations are whipsawing, neither side may feel confident enough in their estimates to put a number on paper. An uncapped SAFE is, in a way, both parties agreeing to punt on valuation entirely: we’ll figure it out when there’s a priced round.

The prevalence of uncapped SAFEs during periods of market uncertainty seems counterintuitive at first. But it makes more sense when you consider the selection effects. In a tight market, fewer deals get done overall. The deals that do happen tend to be for the strongest companies, the ones where founders have enough leverage to push for uncapped terms. The marginal deals, where investors would typically demand more protection, simply aren’t getting done at all. So the average terms you observe shift in a founder-friendly direction, even though the overall market is investor-friendly. Headline metrics can be misleading if you don’t think carefully about which deals are being done versus which deals aren’t happening at all.

The Shift Toward Simpler SAFE Terms

The other trend worth noting is the move toward simplification. A growing proportion of SAFEs carry only a valuation cap with no separate discount rate. When a SAFE has both a cap and a discount, the investor converts at whichever mechanism gives them the better price. In most outcomes, the cap or the discount will dominate, making the other term redundant. By dropping the discount and keeping only the cap, parties simplify the instrument without giving up much in practice.

It also reflects the broader evolution of the SAFE as a standardized instrument. Y Combinator’s standard SAFE template has been gravitating toward simplicity, and the market has largely followed. Fewer terms means faster closings, less legal review, and fewer potential points of negotiation.

For founders raising on a SAFE, you should expect a valuation cap in most cases. If you’re in a position to negotiate an uncapped SAFE, it probably means you have strong leverage, either because your company is performing well or because you’re in a competitive fundraising environment.

For investors, the trend toward simpler cap-only SAFEs means the valuation cap is doing essentially all of the economic work in the instrument. Getting the cap level right matters more than ever because there’s no discount to fall back on. If the cap is set too high, the investor may end up with conversion economics that don’t justify the early risk they took.

Part 3: Post-Series A Bridge Dynamics

Why Post-Series A Bridges Exist

Most people associate convertible instruments with early-stage companies that haven’t done a priced round yet. That’s fair. But one of the more revealing patterns in venture data is the use of convertible instruments after a company has already raised a priced equity round, specifically bridge convertibles issued between a Series A and whatever comes next.

After a Series A, the path is supposed to be straightforward: hit your milestones, grow into a higher valuation, and raise a Series B. But reality is messier. Product timelines slip. Market conditions change. Growth rates don’t always follow the trajectory everyone agreed on in the board deck. When a company needs capital between rounds but isn’t in a position to raise a full priced equity round, a bridge convertible is the typical solution.

Why Notes Beat SAFEs for Bridges

When investors are putting money into a bridge after a Series A, the dynamics are different from an early-stage bet. The company has a known valuation from the Series A. There are existing investors with preferences and rights. The risk profile is more defined, and so are the expectations.

Convertible notes offer features that matter in this context. Interest accrual compensates investors for the time value of money while they wait for conversion. A maturity date creates a timeline for resolution. And the debt-like structure provides some downside protection if things go sideways. None of these features exist in a standard SAFE. When an investor is writing a bridge check into a company between rounds, they want to know there’s a forcing mechanism. A maturity date means the company can’t just sit on your money indefinitely. These are the kinds of structural features that become more important when the stakes are higher and the uncertainty is more defined.

The Valuation Cap Question in Bridges

The valuation cap on a post-Series A bridge is one of the most informative data points you can look at. When the cap is set above the last round’s post-money valuation, it’s a signal that everyone expects the company to raise its next round at a higher price. The bridge is just a timing play, and the cap reflects optimism about where the company is headed.

But when the cap is set at or below the last round’s valuation, that’s a different story entirely. That’s a bridge down round, which means the company and its investors are acknowledging that the business is worth less than it was at the Series A. When down rounds represent a meaningful share of all bridge financings, as they did by 2023, it tells you that a lot of companies aren’t progressing the way their Series A story assumed. The company gets the capital it needs, but the terms make it clear that progress hasn’t matched expectations.

Discount Rates on Bridges

Discount rates on post-Series A bridge notes tend to follow the same conventions as earlier-stage convertibles, with 20% being the most common. A 20% discount on a post-Series A bridge typically applies to the Series B price, which means the bridge investor converts at a 20% discount to whatever the next round looks like.

The bridge investor gets a meaningful advantage over the Series B investors as compensation for the risk they took by writing a check when the company needed it. But the discount interacts with the valuation cap in ways that can create surprising outcomes. If the Series B comes in at a high valuation, the cap might dominate. If it comes in lower, the discount might dominate. Getting both terms right matters because the interplay determines what the bridge investors actually pay per share.

In tighter fundraising environments, bridge investors have more leverage to demand better terms, and higher discount rates are one of the ways that plays out.

Bridge Activity as a Market Signal

The prevalence of post-Series A bridges is one of my favorite indicators of market health, because it captures something that other metrics miss. When bridge activity is high, it means companies are struggling to close full rounds. They need the capital, but they can’t get a deal done on terms that work for a priced equity round. The bridge is a stopgap.

When bridge activity is low, it usually means the market is healthy enough that companies can go straight from Series A to Series B without needing interim financing. That’s the ideal scenario, but it requires a combination of strong company performance, available investor capital, and a valuation environment that allows for smooth step-ups between rounds.

It’s also worth noting that bridge rounds have a self-reinforcing quality at the portfolio level. When one company needs a bridge, it doesn’t necessarily mean much. But when three or four companies all need bridges at the same time, it puts pressure on the fund’s reserves. VCs typically hold back capital for follow-on investments in their winners, and if that reserve capital gets allocated to bridges for struggling companies instead, it changes the fund’s entire portfolio strategy. When bridge activity spikes, the average check size in those bridges tends to be conservative, suggesting that investors are spreading thinner to keep more companies alive rather than making concentrated bets on their strongest performers. That’s a rational response in the moment, but it’s a fundamentally different capital allocation strategy than what most LPs signed up for.

Part 4: What Happens When Instruments Stay Unconverted

SAFEs and convertible notes are designed to be temporary. You raise a quick round, the money carries you to your next priced financing, the instruments convert, and everyone moves on with a clean cap table. That’s the theory. In practice, the “temporary” part can stretch a lot further than anyone planned for, and when it does, the consequences compound in ways that catch both founders and investors off guard.

The Three Costs of Extended Conversion Timelines

When convertible instruments stay outstanding longer than expected, three things happen. Each one is manageable on its own. Together, they can meaningfully change the economics of your round.

Interest accrual on convertible notes. For convertible notes (as opposed to SAFEs), interest accrues for as long as the note is outstanding. A note with an 8% annual interest rate that sits unconverted for 24 months accrues 16% additional principal. When that note eventually converts, the investor receives 16% more shares than they would have if conversion had happened shortly after issuance. That’s dilution that accumulates silently in the background while the note is outstanding, and it compounds further if the conversion timeline stretches to 30 or 36 months.

The interest rate on a convertible note feels like a minor detail during negotiation, especially when everyone assumes conversion will happen within a year. But when the timeline doubles, the difference between a 5% rate and an 8% rate becomes material. It’s worth negotiating hard on this term, particularly in environments where fundraising timelines are uncertain.

Cap table complexity and SAFE stacking. Every unconverted instrument adds uncertainty to the cap table. When a company has multiple SAFEs and notes outstanding, each with different valuation caps, discounts, and issue dates, calculating the fully diluted ownership picture becomes a genuine exercise.

I’ve seen cap tables where the conversion waterfall analysis ran to dozens of pages because of stacked convertibles with conflicting terms. That complexity isn’t just an accounting headache. It slows down due diligence when you actually try to raise a priced round, because incoming investors need to understand exactly what the post-conversion ownership will look like before they can make an offer. The irony is painful: the complexity created by extended conversion timelines can itself slow down the priced round that would resolve them, creating a feedback loop.

This problem is especially pronounced when founders choose to raise additional convertible instruments rather than doing a priced round at a valuation they’re not happy with. Stacking SAFEs on top of existing SAFEs on top of an outstanding convertible note creates a tower of unconverted paper that gets harder to untangle with each new layer. Sometimes this is the right call (a bridge to get to better metrics makes sense). But it should be a deliberate choice, not a default, and founders should understand the cumulative complexity they’re adding each time.

Misaligned economics for SAFE holders. SAFEs don’t carry interest, but the dilution dynamics shift as conversion timelines extend. The longer a SAFE sits unconverted, the more likely it is that the company’s actual value has diverged from the valuation cap. If the company’s value has declined, the SAFE holder may end up with an outsized ownership position at conversion. If value has increased significantly, the cap does more work protecting the investor, which means more dilution for founders than they might have expected.

Either scenario can create tension at the conversion event. Founders may feel that early SAFE holders are getting too good a deal relative to their risk, while SAFE holders may feel that their extended duration of risk exposure (without any of the protections that come with priced equity, like board seats, information rights, or protective provisions) isn’t adequately compensated. Neither side is wrong, exactly. The problem is that the instrument wasn’t designed for the timeline it ended up on.

Why Timelines Stretch

The primary driver is straightforward: companies take longer to raise priced rounds. When the venture financing market slows down, the path from SAFE to Series Seed, or from bridge note to Series B, takes longer than founders planned for. In a fast market, you might close a SAFE and have it convert within 12 months. In a slow one, that same conversion might take 18 months, 24 months, or longer.

But there’s a secondary driver worth understanding. In uncertain valuation environments, founders sometimes prefer to raise another convertible instrument rather than doing a priced round at a valuation they find disappointing. This is rational in isolation (why lock in a low price if you think your metrics will improve?), but it extends the timeline for all outstanding instruments and stacks more unconverted paper onto the cap table.

There’s also a psychological component that doesn’t show up in the data but that I heard about repeatedly from founders and investors. Once a convertible instrument has been outstanding for 12 or 15 months, there’s a tendency to think “well, we’ve come this far, might as well wait for a better environment.” The sunk cost fallacy applies to fundraising timelines too. Founders who could have done a reasonable priced round at month 12 sometimes choose to wait for month 18 or 24, hoping for better terms. Sometimes that bet pays off. Often, it just adds more interest accrual and more complexity for a marginal improvement in valuation.

This dynamic can show up in the data as a divergence between rising valuation caps and declining investment amounts at the earliest stages. Founders anchor to high valuation expectations while investors write smaller checks. Rather than meeting in the middle with a priced round, both sides kick the can down the road with additional convertible instruments.

Practical Guidance

A few takeaways, drawn from watching how these instruments actually play out.

For founders raising on convertibles: Build your financial model with a realistic assumption about how long conversion might take. If you’re modeling a 12-month path to your next priced round, pad it by at least 50%. The cost of being wrong on the optimistic side (running out of runway, accumulating more dilution than planned, adding complexity to your cap table) is much higher than the cost of being conservative. Also, pay attention to interest rates on convertible notes. When timelines were short, interest rates were nearly irrelevant. Over a 24-month horizon, they matter.

For investors writing convertible instruments: Pay attention to the overall stack of convertibles a company has outstanding. If you’re the fourth SAFE on the pile, your conversion economics may look very different from what the headline terms suggest. Also, recognize that extended timelines mean you’re bearing company-specific risk for longer without the protections of a priced equity position. A SAFE holder doesn’t have a board seat. They’re along for the ride, and the ride might be longer than anyone intended.

For both sides: The convertible instrument is a tool designed for speed and simplicity. When conversion timelines stretch, both of those advantages erode. If you find yourself reaching for another convertible round because the alternative is a priced round you don’t love, think carefully about the cumulative cost. Sometimes the priced round, even at a valuation that feels low, is the cleaner path forward.

And for anyone tracking the market more broadly, watching the prevalence of uncapped SAFEs and post-Series A bridge activity together gives you a surprisingly useful picture of market sentiment. When uncapped SAFEs rise and bridge activity climbs, it tells you that uncertainty is high and timelines are stretching. When both metrics pull back, confidence is returning and the conversion machinery is working as intended.

The convertible instrument is one of venture capital’s great innovations. It solved a real problem (how do you invest in a company that’s too early to price?) and it does that job well when used as designed. The trouble comes when temporary instruments become semi-permanent fixtures on a cap table.

Whether you’re a first-time founder negotiating your first SAFE, an investor evaluating a bridge opportunity, or a fund manager trying to understand portfolio dynamics, the mechanics matter. Market conditions change the way these instruments behave in practice, even when the legal terms stay the same. A 20% discount in a fast market and a 20% discount in a slow market are technically identical but practically very different. Understanding the mechanics, the tradeoffs, and how these instruments actually behave in the wild is the best protection for both founders and investors.

Further Reading

Some of the data and analysis in this post originally appeared on the Aumni blog, here, here, here, and here.