How Convertible Notes Work in Startup Fundraising

🚀 What Is a Convertible Note?

A convertible note is a debt instrument that converts into equity at a later date — typically during a future priced funding round. It allows startups to raise money without setting a valuation too early.

In essence, it’s a loan that turns into stock.

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🧾 Key Features of Convertible Notes

• Debt instrument: It accrues interest and has a maturity date

• Automatic conversion: Converts into equity in a future round

• Discounts: Early investors receive a discount on the future share price

• Valuation cap: Limits the maximum price at which their debt converts

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📊 Example Scenario

You’re raising $500K using convertible notes. You offer:

• 20% discount

• $5M valuation cap

• 6% annual interest

In your next priced round at a $10M valuation, the note converts based on either the 20% discount or the valuation cap — whichever gives investors a better deal.

So their $500K buys more shares than if they invested directly in the priced round.

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🔍 Benefits for Founders

✅ Delay setting a valuation when it’s hard to price
✅ Close fast — simpler documents than equity rounds
✅ Maintain flexibility if you’re raising incrementally
✅ Can be friendly to early-stage angel investors

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⚠️ Risks and Considerations

• Debt with a due date – If no equity round happens before maturity, founders owe repayment

• Cap table complexity – Accrued interest and multiple notes can complicate things later

• Legal implications – If not converted, the note becomes debt on the books

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🧠 Convertible Notes vs. SAFEs

💡 Y Combinator recommends SAFEs for simplicity, but some investors still prefer convertible notes due to the maturity and interest protection.

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📁 When Should You Use a Convertible Note?

✅ You’re in a pre-seed or bridge round
✅ You need capital fast, but haven’t priced your round
✅ You expect a larger priced round soon
✅ Your investors are familiar with convertible notes