Let's look at two key terms in early stage investing. These are the discount rate and the valuation caps. These terms apply to both convertible notes and to SAFEs, so we aren't differentiating between them at this point. Firstly, discount rates.

This is essentially the percentage discounts on the valuation that a seed stage investor can purchase shares for in the next priced round. Remember, we are in the unpriced seed stage funding round, and the seed stage investor will not have received any equity on investing in the company, but will have to wait until the next price round or a trigger event to convert their investment into equity. So why wait for the waiting round? They would seek some kind of reward, and this is the discount rate at which they can purchase shares for. They will be able to buy shares at a lower price than other new investors in the priced round. The discount rate is usually in the range of 5 to 30%.

Let's do an example. If we were to look at a typical discount of 20%, this means that the early stage investor in the unpriced round would have the right to purchase shares in the following priced round at a 20% discount to the price per share on that deal. Let's assume they initially invested 100,000 in the unpriced round, buying a convertible note or a SAFE, but for these purposes, it doesn't matter which. If the priced round value shares at $1, then new investors would be able to receive a hundred thousand shares in the company for a $100,000 investment.

But the early stage investors and holders of the convertible notes or SAFEs would do better than this as they get to invest at a discount of 20%. Therefore, they acquire the shares for 80 cents per share.

The conversion of the $100,000 convertible or SAFE would deliver them 125,000 shares, 25% more than the current investors would receive for the same investment in that round.

This is the reward they get for undertaking the riskier earlier unpriced round investment at the seed stage.