Securing capital is the fuel for any high-growth venture. However, for early-stage startups, putting a concrete price tag on your company—a valuation—can be notoriously difficult. Set the valuation too low, and you suffer excessive dilution. Set it too high, and you risk a “down round” later that could shatter investor confidence.
At SGI Consultants, we have guided over 2,000 entrepreneurs through this exact dilemma. With over £250 million in total funding secured and a 90% funding success rate, we know that the vehicle you use to raise funds is just as important as the capital itself.
This guide explores the two most popular instruments for bridging the “valuation gap”: Convertible Notes (Loan Notes) and SAFE Agreements (and their UK equivalent, the ASA).
We will dissect how they work, the critical terms you must negotiate, and how they affect your cap table in the long term.
The Valuation Gap: Why These Instruments Exist
Before diving into the mechanics, it is essential to understand why founders use these instruments. In a traditional “priced round” (e.g., Series A), you sell a specific percentage of your company for a specific amount of money based on a pre-agreed valuation.
For a pre-revenue startup or a company in a “bridge” phase, agreeing on that valuation is often speculative and contentious.
Convertible instruments kick the can down the road. They allow investors to give you cash now in exchange for the right to receive equity later—usually at a future “priced round”—often at a discount to reward their early risk.
What is a Convertible Note (Convertible Loan Note)?
A Convertible Note (often called a Convertible Loan Note or CLN in the UK) is technically a form of debt. It is a loan provided by an investor that converts into equity (shares) in the future, rather than being repaid in cash with interest (though repayment is an option if conversion doesn’t happen).
How It Works
- Investment: The investor lends money to the startup.
- Debt Phase: The money sits on the company’s books as debt. It accrues interest.
- Trigger Event: When a specific event occurs—usually a “Qualified Financing” round (e.g., raising £1M+ in Series A)—the debt and accrued interest convert into shares.
Key Terms You Must Know
- Interest Rate: Unlike a bank loan, you rarely pay this in cash. Instead, the interest accrues and is added to the principal, giving the investor more shares upon conversion. Typical rates range from 4% to 8%.
- Maturity Date: The deadline. If the startup hasn’t reached a conversion trigger (raised additional funding) by this date, the investor can demand repayment or negotiate a conversion to equity. This puts pressure on the founder.
- Conversion Trigger (Qualified Financing): The specific threshold of new funding that forces the note to convert into equity.
The Economics: Valuation Cap and Discount Rate
To compensate early investors for taking a risk before the valuation was set, Convertible Notes usually come with two protective mechanisms:
- The Discount Rate: The investor gets to buy shares at a discount compared to the new investors in the future round. A 20% discount is standard. If Series A investors pay £1.00 per share, the Noteholder pays £0.80 per share.
- The Valuation Cap: This acts as a ceiling on the price the Note holder pays. If your company explodes in value and you raise your next round at a £20M valuation, but the early investor had a £5M Cap, they convert their shares as if the valuation were only £5M. This guarantees them a significant ownership stake for their early belief.
What is a SAFE (Simple Agreement for Future Equity)?
Originating from Silicon Valley accelerator Y Combinator, the SAFE was designed to simplify early-stage fundraising. It is not debt; it is a warrant to purchase stock.
How it Differs from Convertible Notes
- No Interest: Because it isn’t a loan, interest does not accrue.
- No Maturity Date: There is no deadline forcing the company to repay the money or go bankrupt. The SAFE sits dormant until a priced round occurs or the company exits.
- Simplicity: Legal costs are generally lower as the documents are shorter and standardised.
Advanced Variants: The UK Context (ASA)
While the term “SAFE” is American, the UK equivalent is the Advanced Subscription Agreement (ASA).
SGI Insight: If you are raising funds in the UK and want your investors to benefit from SEIS or EIS tax relief, you generally cannot use a Convertible Loan Note, because CLNs are treated as debt, and debt does not qualify for these tax schemes. An ASA, however, is considered purely equity-facing and is usually SEIS/EIS compatible.
Convertible Notes vs. SAFE/ASA: A Strategic Comparison
Choosing between these instruments depends on your strategy and jurisdiction.
| Feature | Convertible Note (CLN) | SAFE / ASA |
| Nature | Debt instrument | Contractual right to equity |
| Interest | Yes (accrues to principal) | None |
| Maturity Date | Yes (repayment risk) | None (usually) |
| SEIS/EIS (UK) | Generally Not Eligible | Generally Eligible (ASA) |
| Complexity | Higher (more legal terms) | Lower (standardized) |
| Founder Favor | Medium (maturity date pressure) | High (no repayment pressure) |
| Investor Favor | High (debt protection) | Medium (equity risk only) |
Investor vs. Founder Perspective
- Founders prefer SAFEs/ASAs because they remove the ticking clock of a maturity date and eliminate interest calculations that dilute ownership.
- Investors (particularly traditional ones) may prefer Convertible Notes because, in the event of insolvency, debt holders are paid before equity holders. A Note offers a layer of protection that a SAFE does not.
When to Use Convertible Instruments
Through our work with over 2,000 clients, including Cambridge University spin-outs and high-growth tech ventures, we typically recommend these instruments in three specific scenarios:
- Pre-Revenue / Seed Stage: When you are too early for a robust valuation. For example, a company like Planetary Processing (one of our success stories) might use this to secure initial capital without locking in a low valuation before its technology is proven.
- The Bridge Round: If you are between major funding rounds but need cash to extend your runway for another 6-9 months to hit specific KPIs.
- Speed of Closing: A priced equity round requires heavy legal due diligence, a shareholders’ agreement, and updated Articles of Association. A Convertible Note or ASA can often be closed in days, allowing you to get back to work.
How to Set the Valuation Cap and Discount
This is where negotiation becomes an art form.
The Discount Rate
Standard market practice is between 10% and 25%.
- 20% is the most common.
- Anything above 25% can be seen as predatory unless the company is in distress.
The Valuation Cap
The Cap is essentially a “proxy valuation.” It signals to the investor the maximum price they will pay.
- Too Low: You risk excessive dilution. If you set a £2M cap and raise your next round at £10M, your early investors get 5x the value instantly, eating up a massive chunk of your equity.
- Too High: Investors may feel the deal isn’t sweet enough compared to the risk.
SGI Strategy: We advise setting the Cap slightly higher than your current estimated fair market value to account for the growth you will achieve before the conversion triggers.
The “Dilution Bomb”: Cap Table Impact
One of the biggest risks with convertible instruments is neglecting to model the conversion.
When the “Qualified Financing” happens, all those Notes and ASAs convert simultaneously.
- The discount gives them more shares.
- The accrued interest (on Notes) gives them even more shares.
- The Valuation Cap might give them drastically more shares if your new valuation is high.
If you stack multiple convertible notes on top of each other, you may reach your Series A round and realize the founders own significantly less than expected.
Recommendation: Always maintain a “Pro-Forma Cap Table.” At SGI Consultants, our Business Funding Service includes detailed modelling of these scenarios so you understand exactly what your equity split will look like post-conversion.
Legal Considerations (UK Specific)
Advanced Subscription Agreements (ASA)
To ensure an ASA qualifies for SEIS/EIS, it must meet strict HMRC criteria:
- The money cannot be refundable.
- The longstop date (conversion deadline) must be reasonable (usually no more than 6 months for SEIS/EIS compliance, though, in practice, it can be longer).
- It cannot carry interest.
Convertible Loan Notes
Under UK law, CLNs are complex. You must consider:
- Security: Is the note secured against company assets? (Avoid this if possible).
- Redemption: Can the investor demand cash back if you fail to raise the next round? This creates an insolvency risk.
Conversion Mechanics: A Worked Example
Let’s look at the math.
Scenario:
- Investor A puts in £100,000 via a Convertible Note.
- Terms: 20% Discount, £5,000,000 Valuation Cap.
- Trigger Event: 18 months later, you raise a Series A at a £10,000,000 Pre-Money Valuation. Share price is £10.00.
Calculation 1: The Discount Method
- Series A Price: £10.00
- Discount Price: £10.00 – 20% = £8.00 per share.
Calculation 2: The Cap Method
- The actual valuation (£10M) is double the Cap (£5M).
- Therefore, the investor converts at the Cap price.
- Effective Price: £10.00 * (£5M / £10M) = £5.00 per share.
Result:
The investor converts at the lower of the two prices (£5.00).
Instead of getting 10,000 shares (at £10) or 12,500 shares (at £8), they get 20,000 shares.
What Happens at Exit Before Conversion?
What if you sell the company (M&A) before you raise your Series A?
Most Convertible Notes and SAFEs contain a “Liquidity Premium” or a corporate transaction provision.
Typically, the investor gets a choice:
- 1x-2x Repayment: Get their money back, plus a multiple (e.g., 2x their investment).
- Convert at Cap: Convert into equity at the Valuation Cap immediately before the sale and take their share of the exit proceeds.
Investors will logically choose the option that pays them the most money.
How VCs View Convertible Debt in Series A
When you approach institutional investors (like Albion VC or Octopus Ventures, whom our clients have successfully accessed), they will scrutinise your existing convertible debt.
If you have too much debt converting at a low cap, the Series A investors might worry that the “option pool” for employees and the founder equity is being squeezed too tightly. This creates a “dirty cap table.”
SGI Advice: Keep convertible debt to a manageable percentage of your total targeted raise. It should be a bridge, not a permanent foundation.
Summary: Choosing the Right Path
Navigating convertible instruments requires a balance of financial strategy and legal precision.
- Choose a Convertible Note if: You are indifferent to SEIS/EIS, institutional investors demand debt protection, or you are comfortable with a maturity date.
- Choose an ASA/SAFE if you need speed, simplicity, and, crucially, if your investors require UK tax relief (SEIS/EIS).
How SGI Consultants Can Help
Securing funding is not just about signing a document; it is about executing the process. With an 87% failure rate for self-managed funding attempts across the industry, professional facilitation is the difference between stagnation and growth.
SGI Consultants offers a comprehensive Business Funding Service that manages this entire process for you:
- Strategy: We determine if Debt (Convertible) or Equity (ASA) is your optimal route.
- Modelling: We model the dilution impact on your cap table.
- Documentation: We assist in preparing investor-ready documentation.
- Facilitation: We utilise our database to target investors graded A+ to Z based on fit.
Ready to secure your funding without the headache?
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Kurt Graver is the founder and CEO of SGI Consultants, a business consultancy that has helped over 2,000 entrepreneurs establish successful startups using systematic business development methodologies. An accountant with an MBA and 25 years of commerce and consultancy experience, Kurt specialises in strategic planning, market analysis, and sustainable business growth