Advanced Mechanics: How SAFEs, Notes, and Caps Actually Dilute Ownership
Note: This is an advanced, optional extension of the “Convertible Notes & SAFEs (The Truth)” series. It is intended for founders and operators who wish to see the conceptual risks discussed in previous posts translated into numerical ownership outcomes.
In our previous discussions, we examined the structural architecture of convertible instruments—treating Simple Agreements for Future Equity (SAFEs) as deferred pricing mechanisms and Convertible Notes as legal debt. While the conceptual framework is vital for negotiation, the true “shadow” of dilution is best understood through the mathematical mechanics of conversion. This post uses simplified numerical illustrations to demonstrate how caps, discounts, interest, and instrument stacking transform early capital into final ownership percentages.
How do SAFEs and convertible notes dilute founders?
SAFEs and convertible notes dilute founders based on valuation caps, discounts, interest, and stacking, often producing materially different ownership outcomes than headline valuations suggest.
Scenario 1: The Single Post-Money SAFE with a Valuation Cap
A recurring structural tension arises from the interaction between a high headline valuation and a low valuation cap. If your company raises capital on a post-money SAFE, the ownership sold is immediately calculable based on the cap, regardless of how high your Series A valuation eventually climbs.
Assumptions:
- Founder Shares: 1,000,000
- SAFE Investment: $1,000,000
- Post-Money Valuation Cap: $10,000,000
- Series A Valuation: $20,000,000
Outcome:
- SAFE Ownership at Conversion: 10% ($1M / $10M cap)
- Founder Ownership (Pre-Series A): 90%
Plain English: Even though your Series A investors valued the company at $20 million, the SAFE holder converts at the $10 million cap. The “headline” valuation of $20 million is irrelevant to the SAFE holder’s stake; the cap effectively doubles their ownership compared to a scenario where they invested directly at the Series A price.
Scenario 2: Proliferation Risk and Instrument Stacking
When you layer multiple post-money SAFEs over time, the dilution compounds non-linearly. Under the Y Combinator post-money framework, early SAFE holders are protected from dilution by later SAFEs issued before the priced round; instead, the founders’ common stock absorbs the entirety of that dilution.
Assumptions:
- SAFE 1: $1,000,000 at a $10,000,000 Cap (10% ownership)
- SAFE 2: $1,000,000 at a $20,000,000 Cap (5% ownership)
Ownership Summary:
- SAFE 1 Holder: 10.0%
- SAFE 2 Holder: 5.0%
- Founders: 85.0%
Plain English: In this “stacking” scenario, SAFE 1 did not get diluted by the issuance of SAFE 2. If these had been priced equity rounds, SAFE 1 would have been diluted by the 5% issuance of SAFE 2, leaving them with 9.5%. Instead, the founders lost an extra 0.5% of the company because the post-money SAFE structure forces the common pool to act as the sole “buffer” for all pre-Series A convertible dilution.
Scenario 3: The “Ticking Clock” of Note Interest
Convertible notes, unlike SAFEs, function as debt and accrue interest, which increases the total amount of capital converting into equity over time. This creates a subtle but persistent shift in leverage as the “weight” of the debt grows.
Assumptions:
- Note Principal: $1,000,000
- Interest Rate: 10% per annum (simple interest)
- Time to Conversion: 2 years
- Valuation Cap: $11,000,000
Outcome:
- Total Conversion Amount: $1,200,000 ($1M principal + $200k interest)
- Final Ownership: ~10.9% ($1.2M / $11M)
Plain English: The two-year delay in raising a priced round cost the founders nearly an extra 1% of the company in interest alone. While 1% may seem marginal early on, in a $100 million exit, that “small” difference early becomes a $1 million shift in proceeds later. Stacking notes with interest creates a compounding dilutive effect that is often difficult to intuit until the final cap table is modeled.
Scenario 4: The Dominance of the Cap Over the Discount
In high-growth outcomes, valuation caps almost always drive dilution more than standard discounts. Founders often focus on the “20% discount,” but in a “home run” round, the cap is the only lever that matters.
Assumptions:
- Investment: $500,000
- Terms: 20% Discount OR $5,000,000 Cap
- Series A Price: $4.00 per share (implied $20M valuation)
The Competitive Payouts:
- Applying the 20% Discount: Investor pays $3.20 per share ($4.00 x 0.80)
- Applying the $5M Cap: Investor pays $1.00 per share ($5M cap / $20M round value = 75% effective discount)
Plain English:The investor is entitled to the lower of the two prices. Because the company’s valuation grew 4x between the seed and the A, the cap became a much more powerful dilutive force than the discount. The investor receives 500,000 shares via the cap rather than the 156,250 shares they would have received with only a discount.
Structural Dilution vs. Headline Valuation
These illustrations demonstrate that your eventual ownership is often determined more by the structural choices you make in your seed paperwork than by the headline valuation of your Series A. Stacking multiple instruments, ignoring the compounding effect of interest, and setting caps that anchor future pricing all create large ownership shifts that are difficult to unwind once the “shadow” of conversion becomes reality.
The assessment of conversion mechanics is highly contextual and requires rigorous modeling of various exit and financing scenarios. As your cap table grows in complexity, the interaction between different series of SAFEs and notes can lead to unforeseen outcomes for founders and early employees. This type of modeling is often most useful when reviewed in context, particularly as instruments begin to interact.
Venture capital outcomes are shaped over time by the compounding dynamics of leverage, incentives, and the non-linear math of conversion.