Convertible Instruments for Pre-Seed Funding

Raising pre-seed capital is one of the most delicate stages in a start-up’s journey. At this point, founders often have little more than a concept, an early prototype, or a small group of pilot users. Revenue is limited or non-existent, valuation is highly speculative, and legal costs must be kept tightly under control. For these reasons, many early-stage companies around the world turn to convertible instruments rather than issuing equity outright.

Convertible instruments allow investors to provide funding now in exchange for the right to receive equity later, typically when a priced funding round occurs. 

This article explores how convertible instruments work, why they are popular at pre-seed stage across jurisdictions, and the key legal and commercial considerations for founders.

Why Convertible Instruments Are Popular at Pre-Seed Stage

At pre-seed stage, agreeing a valuation is often the most contentious and uncertain aspect of a fundraise. The company may not yet have clear traction metrics, meaningful revenue or robust financial projections. In many cases, the business is still refining its product, testing market demand or assembling its core team. Any valuation agreed at this point is therefore highly speculative and can quickly appear unrealistic; either too high, deterring later investors, or too low, causing excessive founder dilution.

Traditional equity financing requires the parties to agree a pre-money valuation, amend constitutional documents, issue new shares and often negotiate detailed shareholder agreements covering governance, minority protections and exit rights. These processes take time, incur legal expense and can distract founders from building the business at a critical stage.

Convertible instruments sidestep many of these complexities:

• No immediate valuation required (or valuation deferred via a cap), reducing friction in negotiations.
• Lower legal costs compared to a full equity round, as documentation is typically shorter and more standardised.
• Speed of execution, which is critical when the company needs capital quickly to reach key milestones.
• Flexibility, allowing multiple investors to participate over time without resetting the valuation for each small investment.
• Administrative simplicity, particularly when raising small amounts from several angel investors.

For angel investors and early backers, convertible instruments offer exposure to equity upside while postponing detailed negotiations until a larger institutional round, when a lead investor typically sets terms and establishes a market-based valuation. This alignment of speed, flexibility and deferred pricing explains their enduring popularity at pre-seed stage.

The Main Types of Convertible Instruments

The three most common forms of convertible instruments used in pre-seed financings globally are:

1. Convertible loan notes (CLNs)
2. Advance subscription or advance equity agreements
3. SAFEs (Simple Agreements for Future Equity)

While terminology varies by jurisdiction, the underlying economic logic is broadly consistent.

Convertible Loan Notes (CLNs)

Convertible loan notes (CLNs) are among the oldest and most widely used forms of convertible instruments in early-stage finance. They are debt instruments which convert into equity upon certain trigger events, most commonly a subsequent ‘qualifying’ funding round. They are particularly common where investors want a degree of downside protection while still participating in the upside potential of a fast-growing company.

Under a CLN structure, the investor initially acts as a lender rather than a shareholder. The company receives cash as a loan, and the terms of that loan govern when and how it will convert into shares.

Key Features of CLNs

• Debt structure: The investor lends money to the company, and the company records the amount as a liability on its balance sheet until conversion or repayment.
• Interest: Interest typically accrues at a modest rate (for example, 5–10% per annum). In early-stage companies, this interest is rarely paid in cash; instead, it ‘rolls up’ and converts into equity alongside the principal at the time of conversion.
• Maturity date: CLNs usually include a long-stop or maturity date (often 12–24 months after issue). If conversion has not occurred by that date, the investor may have the right to demand repayment, extend the term or convert at a pre-agreed valuation.
• Conversion triggers: A qualifying equity financing above a minimum threshold, a sale of the company, an IPO or public listing. In a financing round, the loan typically converts automatically into the same class of shares issued to new investors.
• Discount: The loan converts at a discount to the price per share in the next round, commonly between 10–25%. This rewards the investor for committing capital earlier and taking greater risk.
• Valuation cap: Many CLNs also include a valuation cap, which sets a maximum company valuation for conversion purposes. If the next round valuation exceeds the cap, the investor converts as though the valuation were the capped amount, increasing their effective ownership.

Advantages of CLNs

For investors:

• Downside protection as creditors, subject to local insolvency law.
• Priority over shareholders in liquidation, improving recovery prospects if the company fails.
• Equity upside through the combined effect of discount, valuation cap and accrued interest.

For founders:

• Speed and simplicity compared to negotiating a full priced equity round.
• Deferral of valuation discussions, which can be contentious at pre-seed stage.
• Flexibility, allowing capital to be raised from multiple investors under largely similar terms.

Risks and Considerations of CLNs

• Repayment risk: If no qualifying round occurs before maturity, the company may face repayment obligations at a time when it is least able to meet them.
• Balance sheet impact: As debt, CLNs may affect leverage ratios and how the company appears to future investors or lenders.
• Insolvency implications: If the company approaches financial distress, directors’ duties may shift towards creditors, including noteholders.
• Tax treatment: Interest deductibility, withholding taxes and the tax consequences of conversion vary widely by jurisdiction.

Because CLNs are debt instruments, they may not always be optimal where founders wish to avoid repayment risk or where local tax incentives and regulatory frameworks favour equity-like structures. Careful modelling and legal advice are therefore essential before adopting this approach.

Advance Subscription or Advance Equity Agreements (ASAs)

In many jurisdictions, companies use convertible instruments that are not structured as debt but instead create contractual rights to receive shares in the future. These are commonly referred to as advance subscription agreements (ASAs), advance equity agreements, or pre-paid share agreements. Although terminology varies, the underlying concept is consistent: the investor provides capital now in exchange for a right to be issued equity upon the occurrence of a defined future event.

Unlike convertible loan notes, these convertible instruments are not loans. The investor is not acting as a creditor and does not typically receive interest. Instead, the arrangement is framed as a pre-payment for shares which will be issued later. This distinction has important legal, accounting and tax implications in many countries.

Under these structures, the investor pays money upfront in exchange for a right to be issued shares when a specified event occurs, most commonly a qualifying equity financing led by new external investors. The economic outcome may closely resemble that of a convertible loan note, but the legal mechanics differ.

Key Features of ASAs

• Not debt: There is no loan relationship. The company does not owe repayment as a general matter, and no interest accrues. Repayment rights, if any, are usually limited to narrow circumstances such as breach of contract or failure to meet specific conditions.
• Automatic conversion: On a qualifying funding round above a specified threshold, the agreement converts automatically into the same class of shares issued to new investors, typically at a preferential price.
• Discount and/or valuation cap: As with convertible loan notes, investors often receive a discount to the next round price and/or benefit from a valuation cap. This ensures that early backers are rewarded for the additional risk they assume at pre-seed stage.
• Long-stop mechanism: If no qualifying funding round occurs by a specified date, the agreement may provide for shares to be issued at a pre-agreed valuation or at the valuation cap. This avoids indefinite uncertainty and ensures that the investor ultimately receives equity.

Advantages of ASAs

Advance equity-style agreements offer several practical benefits:

• No repayment obligation, which reduces financial pressure on the company and eliminates the risk of a cash call at maturity.
• Cleaner balance sheet treatment, as the funds are generally not recorded as debt, which can make the company appear less leveraged to future investors.
• Regulatory and accounting simplicity, depending on local law, as the instrument may avoid some of the complexities associated with debt securities.
• Alignment with tax incentive regimes, where applicable, particularly in jurisdictions which provide favourable treatment for equity investments but impose restrictions on debt instruments.

Disadvantages of ASAs

Advance equity agreements, while simple and founder-friendly, have several disadvantages:

• They provide no creditor protection, so investors have limited security if the company fails. 
• They carry no interest, offering no financial return before conversion. If a qualifying funding round is delayed, investors may wait indefinitely for shares, creating uncertainty. 
• Multiple agreements with different valuation caps or discounts can complicate the capital structure, making future fundraising rounds more difficult to manage and potentially causing unexpected dilution for founders. 
• In some jurisdictions, regulatory or tax treatment may be less favourable compared to debt-based instruments, requiring careful planning.

However overall, because these agreements avoid the creditor relationship inherent in loan notes, they are often perceived as more founder-friendly convertible instruments while still offering investors meaningful upside protection through discounts and caps. 

As a result, they have become increasingly common convertible instruments in start-up ecosystems seeking a streamlined, flexible alternative to traditional convertible debt, particularly at the pre-seed and seed stages where speed and simplicity are paramount.

SAFEs (Simple Agreements for Future Equity)

SAFEs (Simple Agreements for Future Equity) originated in the United States through Y Combinator, a startup accelerator, and were introduced as a streamlined alternative to convertible loan notes. Their purpose was to remove many of the complexities associated with debt-based instruments and to create a founder-friendly, standardised mechanism for early-stage investment. Since their introduction, SAFEs have become one of the most widely recognised pre-seed funding convertible instruments in the US start-up ecosystem.

A SAFE is a contractual right to receive shares in the future, without being debt and typically without interest or a maturity date. The investor provides capital upfront in exchange for the right to obtain equity when a defined triggering event occurs, most commonly a priced equity financing round led by institutional investors.

Unlike convertible loan notes, SAFEs are deliberately designed to avoid the legal features of debt. There is no loan, no accrual of interest, and no obligation on the company to repay the investment merely because time has passed. This simplicity reduces negotiation time and allows founders to focus on building the business rather than servicing financial instruments.

In practical terms, SAFEs are economically similar to advance equity agreements. Both involve upfront payment in exchange for future equity, without creating a creditor relationship. The primary differences lie in drafting style, market familiarity and jurisdiction-specific legal considerations.

Core Characteristics

• No interest: The invested amount does not accrue interest over time, meaning there is no increasing liability on the company’s balance sheet.
• No repayment obligation: There is typically no maturity date and no right for the investor to demand repayment, even if a priced round does not occur within a specified period.
• Conversion on equity financing: SAFEs convert into shares when the company completes a qualifying equity financing. The investor usually receives the same class of shares issued in that round.
• Valuation cap and/or discount: Most SAFEs include either a valuation cap, a discount to the next round price or both. These mechanisms reward early investors by ensuring they receive equity on favourable terms compared to later investors.
• Minimal investor control rights prior to conversion: SAFE holders are not shareholders until conversion. As a result, they generally do not have voting rights, board seats or other governance rights before the triggering event.

In the United States, SAFEs are widely used and highly standardised, with widely recognised templates reducing legal friction. Investors and founders are familiar with their mechanics, which facilitates rapid execution of pre-seed rounds, particularly in accelerator-driven ecosystems.

In other jurisdictions, however, local legal adaptations are often required to ensure compliance with company law, securities regulations and tax rules. Certain legal systems may require specific authorisations for future share issuances, impose restrictions on pre-paid equity arrangements or treat SAFEs differently for accounting purposes. In addition, investor tax incentives available in some countries may not apply straightforwardly to SAFE investments without careful structuring.

For founders, SAFEs offer speed, simplicity and limited negotiation. For investors, they provide structured upside participation with relatively low transaction costs. However, because they lack maturity dates and repayment rights, they offer less downside protection than convertible debt.

Founders should ensure that any SAFE-style document is properly adapted to local law and reviewed for regulatory, corporate and tax compliance before use. Careful drafting and scenario modelling remain essential, even where the documentation appears simple.

Key Economic Terms of Convertible Instruments

Regardless of structure, convertible instruments usually revolve around a small set of core commercial variables. Understanding how these variables interact is essential for both founders and investors, as small changes in drafting can have significant effects on dilution and ownership outcomes.

1. Discount

The discount in convertible instruments entitles the investor to convert at a lower price per share than new investors in the next priced equity round. For example, a 20% discount means that if new shares are issued at £1.00 (or the equivalent in local currency), the convertible investor will convert at £0.80 per share.

The logic behind the discount is straightforward. Pre-seed investors commit capital at a stage when the company is unproven and highly risky. They are often investing before there is substantial revenue, product-market fit or institutional validation. The discount compensates them for taking that early risk and for providing capital which facilitates the company to reach the next milestone.

However, founders should appreciate that discounts increase dilution. The higher the discount percentage, the more shares will be issued to the convertible investor relative to later investors contributing the same amount of money.

2. Valuation Cap

A valuation cap in convertible instruments sets a ceiling on the company’s valuation for the purpose of calculating the conversion price. If the next funding round takes place at a valuation above the cap, the convertible investor converts as though the valuation were the capped amount.

For instance, if:

• Cap = 4 million 
• Next round valuation = 8 million

The investor converts at the lower 4 million valuation. This effectively doubles the investor’s relative equity position compared to converting at the full 8 million valuation.

Valuation caps are particularly important in high-growth scenarios. Without a cap, an investor relying solely on a discount might receive only modest additional equity if the company’s valuation increases dramatically. The cap ensures meaningful participation in upside.

3. Qualifying Funding Round

A qualifying funding round is typically defined in convertible instruments as an equity financing above a specified minimum threshold. 

This threshold ensures that automatic conversion occurs only when the company has raised a substantial amount of capital from external investors, usually led by a professional or institutional investor. It prevents premature or trivial financings from triggering conversion on unfavourable terms.

4. Long-Stop Date

Some convertible instruments include a long-stop date, providing that if no qualifying funding round occurs by a specified deadline, conversion will take place anyway at a pre-agreed valuation or at the cap. 

This avoids indefinite uncertainty and ensures that the investor ultimately receives shares rather than remaining in a perpetual pre-conversion position.

Strategic Considerations for Founders of Convertible Instruments

Convertible instruments are powerful tools at pre-seed stage, but they must be used thoughtfully. What appears simple at the outset can create unintended complexity by the time the company raises a priced seed round. Founders should approach early convertible financings with a clear long-term capital strategy in mind.

1 – Avoid Over-Stacking Convertible Instruments

It is common for pre-seed companies to raise multiple small investments over time from angels, friends, syndicates or early-stage funds. Each investment may be documented separately, sometimes on slightly different terms. However, stacking too many convertible instruments with varying caps, discounts and special rights can create a highly complex capital structure.

By the time of the seed round, the company may have:

• Several different valuation caps agreed at different moments in time.
• Different discount rates across investors.
• Accrued interest in the case of convertible loan notes.
• Side letters granting bespoke rights such as information rights or enhanced conversion terms.

This patchwork approach can make modelling dilution extremely difficult. It may also create tension among early investors if their terms differ materially. 

More importantly, institutional investors conducting due diligence at seed stage may be concerned by unnecessary complexity. Venture capital funds typically prefer a clean capitalisation table and predictable conversion mechanics. Excessive variation can slow down negotiations or require costly restructuring before a new round can proceed.

2 – Be Careful with Low Valuation Caps in Convertible Instruments

A low valuation cap can be an effective way to incentivise early investors and close funding quickly. However, founders should think carefully about the long-term consequences. If the cap is significantly below the valuation achieved in the next priced round, dilution may be far greater than anticipated.

For example, raising 300,000 on a 2 million cap, followed by a 5 million seed round, can result in a substantial equity allocation to pre-seed investors. What initially appears to be modest dilution may, in practice, materially reduce founder ownership.

Careful scenario modelling under multiple valuation outcomes is essential before agreeing terms. Founders should assess best-case, base-case and downside scenarios to understand the full impact on the cap table.

3 – Ensure Convertible Instruments Align with Future Institutional Investors

Many venture capital funds have strong preferences regarding capital structure and documentation standards. Clean, standardised convertible instruments are far more likely to be acceptable than heavily bespoke documentation.

Founders should aim for:

• Clear and unambiguous definitions.
• Limited investor-specific variations.
• Conversion mechanics which integrate smoothly into a priced equity round.

By thinking ahead to the seed stage, founders can ensure that pre-seed funding accelerates growth rather than creating avoidable friction later.

Investor Perspective

From an investor’s standpoint, convertible instruments are designed to balance risk and reward in an environment of extreme uncertainty. At pre-seed stage, the probability of failure is high. Many companies will pivot significantly, struggle to raise further capital or cease trading before reaching a priced equity round. Investors therefore require mechanisms which recognise the elevated risk they are taking.

The valuation discount and, where applicable, the valuation cap serve as economic compensation for investing at such an early stage. They allow the investor to convert into equity on preferential terms if the company succeeds and attracts later-stage capital at a higher valuation.

However, investors must weigh these potential rewards against meaningful constraints. They typically have no control rights prior to conversion, meaning no voting power, board representation or formal influence over strategy. There is also no guaranteed liquidity; conversion only creates value if the company eventually achieves a successful exit or later financing. 

In the case of non-debt convertible instruments, investors may also face subordination, ranking behind creditors if the company fails. Finally, regulatory and tax implications in the investor’s home jurisdiction can materially affect net returns.

For these reasons, professional angels and early-stage funds often rely on standardised documentation for convertible instruments to manage risk and ensure consistent execution.

Legal and Regulatory Considerations Globally

While the commercial logic of convertible instruments is broadly consistent worldwide, their legal characterisation and regulatory treatment vary significantly from one jurisdiction to another. What is straightforward in one country may trigger complex compliance requirements in another. Founders must therefore look beyond the headline economics and consider the legal framework in which the convertible instruments will operate.

Key issues to consider include:

• Securities law compliance: Many jurisdictions regulate the offer of securities, including convertible instruments. Companies may need to rely on private placement exemptions, comply with accredited or sophisticated investor rules, or provide specific offering documentation. Failure to comply can result in penalties or even rescission rights for investors.
• Corporate authorisations: Local company law may require board and, in some cases, shareholder approval to issue shares upon conversion. Pre-emption rights and statutory capital maintenance rules must also be reviewed.
• Foreign investment restrictions: Cross-border financings may trigger foreign direct investment screening, exchange control regulations or sector-specific ownership limits.
• Tax treatment: Interest deductibility, capital gains taxation, withholding taxes and eligibility for investor tax incentives can materially affect structuring decisions.
• Accounting classification: Whether the instrument is treated as debt, equity or a hybrid under local accounting standards can influence financial reporting and investor perception.

Given these complexities, founders should seek advice from legal and tax advisers familiar with the relevant jurisdictions, particularly where investors are based in multiple countries.

How to Choose Between Convertible Instruments

Choosing the right convertible instrument depends on the company’s objectives, investor preferences, and the broader regulatory and tax environment. Each structure has advantages and trade-offs that make it better suited to certain scenarios.

Convertible Loan Notes (CLNs) may be most suitable when investors desire some degree of creditor protection. Because they are debt instruments, CLNs provide a legal claim to repayment and typically rank ahead of shareholders in the event of insolvency. 

They are also appropriate when the company is confident it will raise a priced equity round before the maturity date, allowing automatic conversion without creating repayment stress. In jurisdictions where debt classification is commercially acceptable and does not create accounting or regulatory challenges, CLNs can provide a straightforward mechanism to reward early investors while preserving flexibility for future funding.

Advance Equity Agreements are often preferred when founders want to avoid repayment obligations entirely. They provide simplicity and balance sheet clarity since they are not treated as debt. 

These convertible instruments are particularly attractive in regions where regulatory frameworks or tax regimes favour equity-like structures for early-stage investment. They reduce the risk of complications at later funding rounds and can be more easily aligned with investor tax incentives.

SAFEs may be appropriate in ecosystems where they are widely understood and accepted. They are particularly suitable for small, founder-friendly rounds where investors are comfortable with minimal control rights prior to conversion. SAFEs provide a quick, flexible solution with limited negotiation, making them ideal for accelerators or early-stage angel syndicates.

Selecting the right convertible instruments requires careful consideration of investor expectations, the company’s financial position and the likely path to future rounds, as well as obtaining comprehensive professional financial and legal advice. 

To find out more about what ‘seed-strapping’ is, you may wish to take a look at our article ‘Deciphering Seed-Strapping’. To explore how business consultancy can help a start up, take a look at our article ‘New Business Consultancy’.

Mary Taylor & Associates

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