🚀 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.
🧾 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
📊 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.
🔍 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
⚠️ 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
🧠 Convertible Notes vs. SAFEs
- Structure — Convertible Note: Debt. SAFE: Equity-like.
- Interest — Convertible Note: Yes (usually 4–8%). SAFE: No.
- Maturity Date — Convertible Note: Yes. SAFE: Usually no.
- Legal Complexity — Convertible Note: Slightly higher. SAFE: Simpler.
- Common In — Convertible Note: Traditional deals. SAFE: YC-style and US startups.
💡 Y Combinator recommends SAFEs for simplicity, but some investors still prefer convertible notes due to the maturity and interest protection.
📁 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
How Conversion Works, Step by Step
The example scenario above shows which terms matter. Here is how the arithmetic plays out, using the same hypothetical terms and some simple round numbers.
For example, suppose the $500K note converts exactly 12 months after closing, and your priced round values the company at $10M pre-money with 5 million shares outstanding, so new investors pay $2.00 per share.
- Add accrued interest: At 6% simple interest for one year, $500K becomes $530K owed to noteholders. (Many notes convert interest into shares rather than paying it in cash.)
- Calculate the discount price: $2.00 × (1 − 20%) = $1.60 per share.
- Calculate the cap price: $5M cap ÷ 5 million shares = $1.00 per share.
- Apply the better deal: Investors convert at the lower price, $1.00.
- Shares issued: $530K ÷ $1.00 = 530,000 shares, versus 265,000 shares if the same $530K had bought in at the round price.
Your actual note will define exactly which shares count toward the cap price and how interest is treated, so model your real terms before the round closes.
Key Terms to Negotiate
- Maturity date: Give yourself realistic time to reach a priced round. Too short and you may face a repayment conversation before you are ready.
- What happens at maturity: Check whether the note can be extended, converted at a set valuation, or must be repaid. Our guide to what happens when convertible notes mature covers these scenarios.
- Qualified financing threshold: Notes often convert automatically only if the next round raises at least a set amount. Make sure that bar is achievable.
- Change-of-control terms: Understand what noteholders receive if the company is acquired before conversion.
Common Mistakes Founders Make
- Forgetting that interest keeps adding to the amount that converts.
- Issuing several notes on different terms without a single model of total dilution.
- Treating the maturity date as a formality rather than a real deadline.
- Setting a cap without thinking about how it signals value to your next lead investor.
What This Means for Founders
A convertible note is a practical way to raise early or bridge capital without fixing a valuation, but it is still debt until it converts. Treat the interest, maturity and conversion terms as seriously as you would a priced round, keep your cap table model current, and talk to your noteholders early if a priced round is taking longer than planned.
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