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  • Are SAFE and Convertible Discount Rates as Important as Valuation Cap?

    Posted by Brian on September 28, 2022 at 2:05 pm

    One question I got recently is whether “SAFE and Convertible Discount Rates as Important as Valuation Caps”?

    And are high discount rates a negative signal for investors (think about sales of 50% off assets sometimes indicating something about the items being sold, perhaps being of a lower quality or needing to be offloaded).

    Here’s how I’d look at discount rates of SAFEs as a potential investor…

    TLDR: I don’t usually put too much focus on the discount rate, unless I have some indication that the company plans to raise another round where they might convert in a very short timeline, e.g. the next 6-12 months, or if the valuation cap seems unreasonably high to me.

    The only time that a discount rate comes into play is if the discount rate gives a better SAFE/note conversion price compared to the valuation cap.

    So to me, it’s kind of a weighting of saying how confident the startup is in the valuation cap – i.e. at a 0% discount, the issuer better be very confident that the valuation cap is reasonable and that they will be able to command a higher valuation in future rounds (otherwise early investors are taking more risk and not being compensated).

    Whereas a 30% discount is perhaps saying they aren’t as sure that their valuation cap is as accurate or investors will be sufficiently enticed by that alone, so it gives some added benefit to early investors if they don’t grow as much as they expect.

    In most instances of investing in SAFEs and Convertible Notes, the valuation cap is probably the more important of the two (to me); but that is based on the assumption that the next fundraising round will either:

    1. Be sufficiently far enough away (in time), such that the company has been able to grow, and thus will command a higher valuation at the next funding round (or whenever it converts), and
    2. Be an up-round in valuation, even if the company raises another round in a shorter timeframe (which means they are growing much faster)

    So if I see a 0% discount rate, I don’t always look at that as a bad thing, as long as:

    1. The company has a positive outlook for growth
    2. The valuation cap is reasonable

    If the valuation cap was way higher than I’d expect, that’s when I may start looking to ensure there is a fair discount rate. So a 30% discount rate on a super high valuation deal could still be somewhat attractive. But that might indicate to me that they are positioning themselves as being a higher valuation than they are actually worth

    Now if I saw a 40%+ discount rate on a SAFE, that would raise questions, since it’s so atypical. Not necessarily a red flag, but something to look into more.

    • This discussion was modified 1 year, 6 months ago by  Brian.
    Brian replied 1 year, 6 months ago 1 Member · 0 Replies
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