Are You a Startup Looking for Funding? A Guide to Equity, SAFEs, and Convertible Notes

Startups are usually born from the vision of ambitious entrepreneurs who believe their innovative ideas can transform industries or bring real value to society. But in today’s competitive landscape, having a great idea is not enough to get a business off the ground. The real question is: do the founders have the fuel capital required to make their vision a reality?

There is a common misconception that entrepreneurs rely solely on their own money to launch their businesses. This is not entirely accurate. In most cases, entrepreneurs begin by presenting and “selling” their business ideas to potential investors who may be willing to provide the initial funding needed for the business to take off. However, not all investors seek the same type of return. Generally, investors fall into two categories, equity investors and non-equity investors, each offering funding in different ways.

This is where various funding instruments come into play, helping bridge the gap between a promising idea and execution. The most commonly used early-stage instruments are:

1. Private equity (priced equity rounds)
2. Convertible notes
3. Simple Agreements for Future Equity (SAFEs)

 

While these instruments are often discussed in commercial terms, their legal nuances are equally important, and it is here that legal advisors play a crucial role, helping founders and investors select the most suitable funding instrument for each particular transaction.

 

Private Equity (Priced Equity Rounds)

One of the primary funding options for startups is private equity, often structured as priced equity rounds. At the early stages, founders often raise capital by offering equity (shares), ownership in the company, in exchange for investment. These rounds typically include pre-seed, seed and post seed funding, followed by Series A, B, and subsequent rounds. Investors in these stages may include angel investors, friends and family, and early-stage venture capital funds.

Equity financing involves issuing shares immediately at a negotiated valuation, which clearly establishes ownership from the outset. The private equity instrument gives investors shareholder rights, including voting rights (if any), dividends, and exposure to both the risks and rewards of the business.

However, for equity financing to work effectively, two major components must be carefully structured:

1. Corporate Structure

Startups must be strategic when selecting the jurisdiction in which to incorporate their business. In the UAE, this decision is particularly important, as many entrepreneurs are unaware of the differences between jurisdictions, the types of free zones, and the benefits and restrictions each offers in relation to business activity and future growth plans.

Many startups, with legal assistance, choose to incorporate in financial free zones such as the Abu Dhabi Global Market (ADGM) or the Dubai International Financial Centre (DIFC). These jurisdictions are often preferred because they offer:

1. Common-law frameworks
2. Flexible shareholding structures
3. The ability to issue multiple classes of shares
4. Investor-friendly regulations

However, mainland UAE companies, governed by the UAE Commercial Companies Law (Federal Decree Law No. 32 of 2021), offer limited flexibility particularly regarding share classes, restricted nominal share values, the transfer of fractional shares, and mechanisms in which as drag-along and tag-along rights can be exercised.

There is often confusion between financial free zones and economic free zones in the UAE. Some economic free zones, such as the Dubai Multi Commodities Centre (DMCC), are not based on common law but follow federal laws alongside their own regulations. While these zones are evolving, practical challenges remain. For example, DMCC do not fully allow the transfer of fractional shares. This creates difficulties for founders who need to set specific valuations and allocate shares to investors based on the nominal value of each share, which is often set at a minimum of AED 1,000. As a result, the minimum transferable block is typically 10 shares, equivalent to AED 10,000. Although the regulations may appear flexible on paper, these provisions are not always implemented in practice.

Therefore, financial free zones such as ADGM and DIFC remain the most sophisticated and investor-friendly jurisdictions in the UAE for modern equity financing, offering practical frameworks that support flexible shareholding structures and facilitate investment.

2. Shareholding Structure

A well-defined shareholding structure is essential to protect both the company and its investors. Investor rights and obligations should be clearly outlined in contractual and statutory documents. To ensure legal protection, all agreed-upon terms should be reflected in the company’s constitutional documents, such as the Articles of Association and shareholders’ agreements.

These documents govern key matters, including but not limited to:

• Management and decision-making rights
• Dividend entitlements
• Voting rights
• Liquidation preferences
• Anti-dilution protections
• Exit mechanisms

Without a clear strategy and proper legal structuring from the beginning, founders may face significant challenges during later funding rounds and when attracting strategic partners.

 

Convertible Notes

One of the flexible early-stage financing options available to startups is the convertible note. Convertible notes are equity-linked debt instruments, a hybrid form of financing that begins as loan with interest but is intended to convert into equity when specific trigger events occur, most commonly during the next qualified funding round. They are often confused with convertible loans, which operate primarily as traditional debt instruments intended for repayment with interest and without a predetermined plan to convert into equity.

Convertible notes offer early investors the opportunity to receive shares in the company at a future date, typically at a discounted valuation or subject to a valuation cap. This structure enables startups to delay valuation discussions until a later, more mature round where market forces can better accurately determine the company’s worth. As such, convertible notes provide a practical compromise between immediate equity issuance and the need to defer valuation.

Key Legal Considerations

For convertible notes to function effectively, the underlying legal documentation must be carefully drafted in the convertible note agreement. Key provisions typically include, but are not limited to:

• Conversion mechanics
• Valuation cap
• Discount rate (if applicable)
• Interest rate
• Maturity date
• Events of default

Some investors may also negotiate protective provisions such as negative covenants or reserved matters, which must be aligned with the company’s Articles of Association and shareholders’ agreements to avoid inconsistencies.

One way for a convertible note to be legally recognized and enforceable is for it to be registered. The DIFC through the DIFC Registrar of Security (ROS) under the DIFC Law of Security No. 4 of 2024 can register convertible notes as long as they are structured to create a security interest.

Registering a new security means officially recording a legal claim on an asset so that it is recognized by law and can be enforced. In this scenario, the company grants the investor a security interest in specific assets (such as shares), which the investor then registers with ROS. However, registration with the ROS is entirely voluntary, and there is no mandatory requirement to do so. ROS can also register security over assets that are located outside the DIFC.

A practical example of the basic idea:

Imagine a founder has a new idea for a specific product and needs funding to develop it. The founder doesn’t yet know how big or valuable the company will become. An Investor agrees to provide AED 100,000 at this early stage, but instead of receiving repayment in cash, the investor negotiate to receive equity once the product is launched and other investors join, at an agreed valuation cap of AED 5,000,000. By taking the risk early and believing in the company before others, the investor is rewarded with more shares for the same investment.

To illustrate how convertible notes work in practice, consider the following scenario:

NH Ltd raises seed funding by issuing convertible notes with a valuation cap of AED 5,000,000 with no discount. Several months later, the company conducts a Series A round at a USD 15,000,000 pre-money valuation, selling shares at USD 15 per share.

The conversion price is calculated as:

Valuation Cap ÷ Series A Valuation × Series A share price = Conversion price

5,000,000÷15,000,000×15 =3.33

This means the investor AED 100,000 investment converts into 30,030 shares, instead of just 6,666 shares if you had purchased at the Series A price of AED 15 per share.

Ultimately, the enforceability and commercial success of convertible notes depend on a clear understanding of the relevant legal framework, jurisdictional nuances, and associated risks. If the startup fails prior to conversion, the noteholder remains a creditor, not a shareholder.

 

Simple Agreements for Future Equity (SAFEs)

Unlike convertible notes, SAFEs are not debt. They are contractual rights to future equity, with no interest and no maturity date. Companies are not obliged to repay a SAFE; it converts into equity only upon a priced funding round or a liquidity/dissolution event. If there’s no priced round, the SAFE remains outstanding until such an event occurs, at which point the SAFE’s terms dictate either cash-out or conversion.

Because SAFEs are considered securities, companies issuing them must comply with applicable laws and regulations. SAFEs are typically shorter and less complex than traditional equity or debt financing documents, which accelerates negotiations and allows startups to focus on building their business. For investors, the main attraction of a SAFE is the potential for significant returns if the startup succeeds and its equity appreciates substantially.

A key feature of SAFEs is the valuation cap, which sets the maximum company valuation at which the SAFE converts into equity. SAFEs may also include a conversion discount, which allows investors to convert their SAFE at a lower price per share than the next funding round, rewarding early risk-taking. Some SAFEs may combine both a valuation cap and a discount, or include an MFN (Most Favoured Nation) clause to protect the investor in future rounds.

A common mistake made by early-stage founders is treating pre-money and post-money SAFEs as if they are the same. Often, founders concentrate on terms like valuation caps and conversion discounts first, leaving the determination of whether the SAFE will be pre-money or post-money to the investors.

 

Pre-Money vs. Post-Money SAFEs

Pre-Money SAFE: The valuation cap (and any discount) is calculated before including SAFE investments or other convertible securities in the company’s capitalization. Investors do not know their exact ownership percentage at the time of investment and may be diluted by future rounds.

Post-Money SAFE: The valuation cap (and any discount) is calculated after including the SAFE round in the company’s post-money valuation. This provides investors with a clearer understanding of their ownership percentage at conversion.

For example, a $1 million investment with a $10 million post-money valuation cap secures 10% ownership at conversion. Post-money SAFEs offer certainty for investors but may increase dilution risk for founders in future rounds.

Therefore, founders must carefully decide between pre-money and post-money SAFEs and consider whether discounts are included, as these affect dilution and investor incentives.

In summary, early-stage funding is a critical step for startups, and selecting the right financing instrument, whether private equity, convertible notes, or SAFEs, can significantly impact both founders and investors. Each option comes with unique legal, financial, and strategic considerations, from shareholding structures to valuation caps and conversion mechanisms. Legal guidance is essential to navigate these complexities and ensure that both the startup’s growth and investor confidence are safeguarded. Ultimately, the right funding strategy balances risk, reward, and long-term scalability..

 

Disclaimer

This publication does not provide any legal advice, and it is for information purposes only. You should not rely upon the material or information in this publication as a basis for making any business, legal, or other decisions. Any reliance you place on such material is therefore strictly at your own risk.

 

Sources:

1. https://www.difc.com/business/registrars-and-commissioners/registrar-of-security
2. https://www.lexismiddleeast.com/law/UnitedArabEmirates/DecreeLaw_32_2021
3. https://help.clara.co/en/articles/7325498-what-is-a-pre-money-safe
4. https://uaelegislation.gov.ae/en/legislations/1542
5. Legal Anatomy of a SAFE: What Founders and Investors Must Know in the UAE – ATB Legal
6. Convertible Notes in UAE: Terms, Triggers, and Legal Risks – ATB Legal
7. Simple Agreement for Future Equity (SAFE): Definition, Benefits, and Risks
8. https://www.commenda.io/blog/pre-money-post-money-safe/