Top Convertible Note Structures for Pre-Seed Startups

Created by Y Combinator, the SAFE is a popular derivative of the convertible note that eliminates complex legal terms like interest rates and maturity dates. It allows for faster closing times and lower legal costs for pre-seed rounds while deferring valuation until the next equity round.

The most traditional form of debt equity hybrid where the lender receives shares at a later financing round at a discount or based on a maximum valuation. This structure protects investors from excessive dilution if the company's value increases significantly before the conversion event.

This structure offers early investors a percentage discount on the share price paid by later investors, typically ranging from 10% to 25%. It serves as an immediate incentive for taking the risk of investing in a pre-seed startup before it has established a firm market valuation.

The Minimum Internal Rate of Return (MIRR) clause guarantees a minimum return on investment, often capped around 20-30%, if the startup exits via acquisition rather than a priced equity round. This provides downside protection for investors in early-stage companies that may not achieve high valuation multiples.

While not a standalone note type, this critical clause is often embedded in convertible notes to allow investors to maintain their ownership percentage in subsequent funding rounds. It ensures early backers can participate in future rounds to avoid dilution of their initial stake.

An even simpler alternative to the SAFE, developed by Y Combinator, which functions similarly but is structured as a traditional debt instrument without the same legal ambiguities. It is designed for speed and simplicity, often used when parties want the flexibility of a note without complex valuation mechanics.

The MFN clause allows earlier note holders to benefit from more favorable terms offered to later note holders before the conversion event occurs. It ensures equity parity among early investors if the startup negotiates better discounts or caps in subsequent tranches of financing.

A variation of the SAFE that specifies how much equity the investor receives based on the fully diluted capitalization including the investment itself. This structure provides greater transparency and certainty for founders regarding dilution compared to pre-money structures.

Unlike SAFEs, standard convertible notes accrue interest on the principal amount, which converts into equity at the next priced round. This adds a slight financial incentive for early investors and increases the total number of shares they receive upon conversion.

These notes are designed for very brief holding periods with an aggressive maturity date, often forcing a conversion or repayment within a year. They are suitable for startups with a clear, near-term path to a Series A round or acquisition, reducing long-term debt liability.

Offering an extended maturity period, these notes give startups more flexibility and runway to achieve significant milestones before conversion. They are less stressful for founders who do not have an imminent financing event but may result in higher accumulated interest for investors.

This structure converts partially at a discount and partially based on a valuation cap, combining two mechanisms to balance investor protection and founder flexibility. It is often used in hybrid deals where both parties want some guaranteed downside protection and some upside participation.

In rare cases, notes are issued without a valuation cap, relying solely on a discount rate for conversion. This is generally unfavorable for early investors but may be used when the startup has extremely strong traction or when negotiating a later pre-seed round with significant leverage.

Some sophisticated early notes include a liquidation preference, ensuring investors get their principal back (sometimes with interest) before common shareholders in an exit scenario. This adds a layer of security similar to Series A preferred stock, though it is less common in very early-stage deals.

A hybrid structure that converts into equity based on future revenue streams rather than a specific financing round. This is rare for pre-seed startups but may be used by companies with existing revenue models seeking growth capital without immediate equity dilution at a low valuation.

In addition to financial terms, some pre-seed notes grant investors the right to observe board meetings, providing governance influence without full board seats. This allows early backers to stay informed about company direction and protect their investment through oversight.

Multiple small investors' notes are aggregated into a single instrument, often through a special purpose vehicle (SPV), to simplify cap table management. This structure is efficient for startups raising from many angel investors, reducing administrative burden during conversion.

A protective clause that may allow investors to reclaim certain benefits or adjust conversion terms if the company fails to meet specific milestones or if subsequent funding rounds reveal undervaluation issues. These are complex and negotiated on a case-by-case basis.

Many accelerators and law firms provide standardized templates for convertible notes to reduce negotiation time and legal fees. Using a widely accepted template can speed up the fundraising process and increase investor confidence by using familiar, market-tested terms.