A convertible note is a short-term debt instrument that converts into equity at a future financing round. It is one of the most common instruments used in early-stage startup financing. Key terms include the discount rate, valuation cap, interest rate, and maturity date.
What Is a Convertible Note?
A convertible note is a form of short-term debt that converts into equity — typically preferred stock — upon the occurrence of a triggering event, usually a qualified financing round. Rather than setting a valuation at the time of investment (which is difficult for early-stage companies), convertible notes defer the valuation question to a later round when there is more data.
Convertible notes are legally structured as loans: the company receives cash, accrues interest, and the investor has the right to convert the outstanding principal and accrued interest into equity at a future date.
Key Terms
Valuation Cap
The valuation cap is the maximum valuation at which the note will convert into equity, regardless of the actual valuation at the next financing round. It protects early investors from excessive dilution if the company raises at a high valuation.
Example: An investor puts in $500,000 on a note with a $5M cap. The company later raises a Series A at a $20M pre-money valuation. The investor's note converts as if the valuation were $5M — giving them 4x more shares than new investors paying the $20M price.
Discount Rate
The discount rate gives note holders the right to convert at a discount to the price paid by new investors in the next round. Typical discounts range from 10–25%.
Example: A 20% discount means if new investors pay $1.00/share, the note holder converts at $0.80/share.
Interest Rate
Convertible notes accrue interest (typically 4–8% annually) that is added to the principal at conversion. This is a legal requirement in most jurisdictions — a 0% interest loan between unrelated parties raises tax issues.
Maturity Date
The maturity date is when the note legally comes due. If the company has not raised a qualified financing round by the maturity date, the investor can demand repayment or negotiate an extension. Typical maturity is 18–24 months.
Qualified Financing
A qualified financing is the triggering event for conversion — typically defined as a priced equity round above a minimum threshold (e.g., $1M raised at a minimum valuation).
How Conversion Works
At a qualified financing:
- Outstanding principal + accrued interest = total conversion amount
- Apply the lower of: (a) cap price or (b) discounted price
- Divide conversion amount by conversion price = shares issued to note holder
Example:
- Note principal: $500,000
- Accrued interest (18 months at 6%): $45,000
- Total conversion amount: $545,000
- Series A price: $2.00/share
- Cap price: $5M cap ÷ 10M shares outstanding = $0.50/share
- Discount price: $2.00 × (1 - 20%) = $1.60/share
- Conversion price: $0.50 (lower of cap and discount)
- Shares issued: $545,000 ÷ $0.50 = 1,090,000 shares
Convertible Note vs. SAFE
| Feature | Convertible Note | SAFE |
|---|---|---|
| Legal structure | Debt | Not debt |
| Interest | Yes | No |
| Maturity date | Yes | No |
| Balance sheet impact | Liability | Equity (typically) |
| Complexity | Moderate | Low |
| Investor protection | Higher | Lower |
SAFEs (Simple Agreements for Future Equity) are simpler and have no maturity date or interest, but offer less investor protection. Convertible notes are more common in markets outside Silicon Valley.
Pros and Cons
For founders:
- ✓ Avoids valuation negotiation at early stage
- ✓ Faster and cheaper to close than priced rounds
- ✓ Flexible terms
- ✗ Creates debt obligation with maturity risk
- ✗ Cap and discount can create significant dilution at Series A
For investors:
- ✓ Downside protection (debt seniority)
- ✓ Cap and discount reward early risk
- ✓ Interest accrual
- ✗ No equity rights until conversion
- ✗ Valuation uncertainty
Key Takeaways
- A convertible note is short-term debt that converts to equity at a future financing round.
- The valuation cap and discount rate are the most economically significant terms.
- Interest accrues and converts along with principal.
- The maturity date creates a repayment risk if the company does not raise a qualified round.
- SAFEs are simpler but offer less investor protection than convertible notes.
Filed under M&A, Partnering & Due Diligence. Working session: Calendly.
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