A convertible note is a debt instrument that converts into equity when a specified trigger event occurs, typically the company’s next priced funding round. It allows startups to raise capital quickly without negotiating a pre-money valuation, deferring that valuation discussion to a later round when the company has more traction and data.
Core Terms
Every convertible note has a few key terms that define how the conversion works:
Valuation cap. The maximum valuation at which the note converts into equity, regardless of how high the actual priced round valuation is. If a note has a $10M cap and the Series A prices at $20M pre-money, the note holder converts at the $10M valuation, receiving twice as many shares per dollar as the Series A investors.
Discount rate. A percentage discount (typically 15-25%) applied to the priced round’s price per share. If the Series A price is $5.00 per share and the note has a 20% discount, the note converts at $4.00 per share. When a note has both a cap and a discount, the holder gets whichever produces the lower conversion price (more shares).
Interest rate. Because a convertible note is legally debt, it accrues interest, typically 2-8% annually. The accrued interest converts into additional shares alongside the principal. The interest is not paid in cash; it simply increases the total amount that converts.
Maturity date. The date by which the note must convert or be repaid, usually 18-24 months from issuance. This creates a structural deadline, though in practice, maturity is often extended by mutual agreement if a priced round has not yet occurred.
When Companies Use Convertible Notes
Convertible notes are most commonly used in three scenarios:
- Early-stage fundraising. Before SAFEs became widespread, convertible notes were the standard instrument for seed rounds. They remain common, particularly with investors who prefer the structural protections of debt.
- Bridge rounds. When a company needs capital between priced rounds, a bridge note lets them raise quickly without a full valuation negotiation. Bridge notes often convert into the next round’s equity on predefined terms.
- International fundraising. SAFEs are a U.S.-centric instrument. In many international jurisdictions, convertible notes are better understood legally and more commonly used.
Conversion Mechanics
When a qualifying financing occurs (usually defined as a priced round above a minimum threshold), the note automatically converts into the same class of preferred stock the new investors receive. The conversion price is determined by the lower of the cap-implied price or the discounted price. The note holder ends up on the cap table alongside the new investors, holding the same class of shares but at a lower effective price per share.
If the company is acquired before the note converts, most notes include a provision that either converts the note at the cap valuation or returns a multiple of the principal (typically 1x-2x) to the note holder.
Risks and Considerations
The debt nature of convertible notes creates risks that SAFEs avoid. A note at maturity is legally due, and an aggressive note holder could technically demand repayment. Multiple notes with different terms create cap table complexity. And the interest accrual, while modest, adds dilution over time. Founders using convertible notes should track the fully converted cap table impact carefully and ensure their legal documents are clean before the next priced round.
Frequently Asked Questions
What is the difference between a convertible note and a SAFE?
A convertible note is debt with an interest rate and maturity date. A SAFE is not debt; it has no interest and no maturity. Notes create an obligation to repay if they do not convert, while SAFEs simply wait for a conversion trigger. SAFEs are simpler, cheaper to execute, and have become the dominant instrument for early-stage raises. Notes remain more common in bridge rounds and later-stage pre-equity financings.
What happens if a convertible note reaches maturity without converting?
If the company has not raised a qualifying priced round by the maturity date, the note technically becomes due. In practice, companies rarely repay the principal. Instead, the company and note holders negotiate an extension, a conversion at agreed-upon terms, or in some cases, the note holder can demand repayment, which can force an uncomfortable conversation or even insolvency for cash-strapped startups.
What is a typical discount rate on a convertible note?
The standard discount rate is 15-25%, with 20% being the most common. This means the note converts into equity at a 20% discount to the price per share in the next priced round. The discount compensates early investors for the additional risk of investing before a valuation was formally established.
