Convertible Note
A convertible note is short-term startup debt with interest and a maturity date that converts into equity when a future priced round closes.
What Is a Convertible Note?
A convertible note is a short-term debt instrument used by early-stage startups to raise capital before conducting a priced equity round. The investor loans money to the company, which carries an interest rate and a maturity date. Rather than being repaid in cash, the principal (and any accrued interest) converts into equity shares when a qualifying financing event occurs — typically a Series A or larger priced seed round.
Convertible notes were the standard early-stage financing instrument for decades before Y Combinator introduced the SAFE in 2013. They remain widely used, particularly when investors want the legal protections that come with holding a debt instrument, or when a startup is raising a bridge round between priced financings.
Why Convertible Notes Exist
Early-stage startups often cannot agree on a valuation with investors. Attempting to set a price too early can be contentious and lead to deals falling apart. Convertible notes sidestep this problem: the investor provides capital now, and the valuation is effectively determined later — at the priced round — with the note investor receiving a better price as compensation for their earlier risk.
Key Terms in a Convertible Note
Interest Rate
Convertible notes are legally structured as debt, so they accrue interest. Most early-stage notes carry an interest rate of 5–8% per year, though rates vary by deal. The interest typically does not get paid in cash — it accrues and converts into additional equity at the conversion event alongside the principal.
Example: A $500,000 note at 6% annual interest held for 18 months accrues $45,000 in interest. At conversion, the investor converts $545,000 (not just $500,000) into equity.
Maturity Date
The maturity date is the deadline by which the note must either convert into equity or be repaid. Common terms range from 18 to 24 months. If a qualifying financing has not occurred by the maturity date, the investor has the legal right to demand repayment of principal plus accrued interest — a situation most startups cannot handle.
In practice, if a startup has not closed a qualifying round by maturity, founders typically negotiate an extension with note holders. Sophisticated investors generally prefer to extend rather than force repayment on a company that is still operating.
Valuation Cap
The valuation cap is the maximum company valuation at which the note will convert. It protects the note investor from excessive dilution if the company’s value has risen significantly since the note was issued.
Example: An investor holds a $250,000 note with a $4M valuation cap. The company raises a Series A at an $18M pre-money valuation. The investor converts as if the company were valued at $4M — receiving more than 4x the shares per dollar compared to Series A investors.
Discount Rate
The discount rate entitles note investors to convert at a price below what new investors pay in the qualified financing round. A 15–25% discount is common. If the note includes both a cap and a discount, the investor typically receives the conversion terms that result in the lower price per share.
Example: A 20% discount on a round priced at $1.00 per share means the note investor converts at $0.80 per share.
Conversion Mechanics
When the qualifying financing closes, conversion happens in three steps:
- The total outstanding principal plus accrued interest is calculated
- The conversion price per share is determined (via cap, discount, or the lower of both)
- The debt is retired and the equivalent number of preferred shares are issued
The note investor typically receives the same class of preferred shares as new investors in the qualifying round, but at the lower (more favorable) price.
What Happens at Maturity If No Round Occurs?
This is the most dangerous scenario for founders. If the maturity date arrives with no qualifying financing:
- Best case: Investors agree to extend the note for another 12–18 months
- Moderate scenario: Investors negotiate conversion into equity at an agreed valuation (often unfavorable to founders)
- Worst case: Investors demand repayment, which most startups cannot fulfill, potentially triggering a default or insolvency
To avoid this, founders should build maturity date extensions into the note from day one, or negotiate a “qualified financing optional conversion” clause that allows early conversion at the investor’s discretion.
Convertible Note vs. SAFE
| Feature | Convertible Note | SAFE |
|---|---|---|
| Legal structure | Debt (loan) | Not debt |
| Interest rate | Yes (typically 5–8%) | No |
| Maturity date | Yes (typically 18–24 months) | No |
| Investor has repayment right | Yes | No (except acquisition/wind-down) |
| Legal complexity | Moderate | Low |
| Conversion trigger | Priced round or maturity | Priced round only |
| Ownership certainty | Determined at conversion | Fixed at signing (post-money SAFE) |
| Common in | Seed, bridge rounds | Pre-seed, seed |
| Preferred by | Investors wanting debt protection | Founder-friendly rounds |
Advantages for Founders
- Avoids the need to set a valuation during an uncertain early stage
- Faster and cheaper to close than a full priced round
- Familiar to a wide range of investors, including those who prefer debt instruments
- Can be issued in tranches or to multiple investors individually
Advantages for Investors
- Holds a senior legal position compared to equity holders (debt ranks ahead of equity in liquidation)
- Accrued interest increases the total amount that converts into equity
- Maturity date creates a natural deadline and point of leverage
- More familiar to traditional finance professionals than SAFEs
Common Convertible Note Terms at a Glance
| Parameter | Typical Range |
|---|---|
| Interest rate | 5–8% per year |
| Maturity | 18–24 months |
| Valuation cap | Varies widely by stage ($2M–$15M for pre-seed/seed) |
| Discount rate | 15–25% |
| Minimum qualifying financing | $1M–$2M |
Key Takeaway
A convertible note is a time-tested early-stage financing instrument that bridges the gap between a startup’s founding and its first priced equity round. Its debt structure gives investors meaningful legal protections while giving founders the flexibility to delay setting a valuation. Compared to a SAFE, a convertible note is slightly more complex and carries more risk for founders at the maturity date — but it remains the preferred instrument for many experienced seed investors. Always model out the dilutive impact of accrued interest and cap-based conversion before issuing notes, and negotiate reasonable maturity dates with extension provisions built in.