What is a Convertible Note?

A convertible note is a specific type of investment vehicle often used in the earliest stages of a startup. Technically, it is a form of short-term debt. An investor loans money to a company, but instead of getting their principal plus interest back in cash, they expect to receive equity in the company at a later date.

It is effectively a delayed equity purchase.

In the early days of a company, putting a specific price tag or valuation on the business is difficult. You might have an idea and a prototype, but no revenue. Arguing with an investor over whether the company is worth two million or four million dollars is a distraction. The convertible note kicks this can down the road. It allows you to take the money now and determine the valuation later when you raise a larger, priced round of funding.

Since a convertible note is legally a loan, it has components that look like a standard bank loan, even if the intent is different.

• Maturity Date: The date by which the loan must be repaid or converted. This is a ticking clock for the founder.
• Interest Rate: The money earns interest over time. However, this interest is rarely paid in cash. Instead, it accrues and is converted into additional shares along with the principal.
• Conversion Trigger: This is usually a “Qualified Financing.” It means the debt automatically turns into shares when the company raises a specific amount of money in a future equity round.

Why would an investor take the risk on a brand new company just to get the same price per share as a Series A investor two years later? They wouldn’t. To compensate early investors for their risk, convertible notes include special terms.

The Discount Rate gives the investor a percentage off the price per share of the next round. If the discount is twenty percent, and the Series A investors pay one dollar per share, the note holder converts their debt at eighty cents per share.

The Valuation Cap is the most critical term. It sets a maximum valuation at which the note can convert. If your company explodes in value and you raise your next round at a twenty million dollar valuation, but the early investor had a five million dollar cap, they convert their shares as if the company was only worth five million. This gives them a significantly larger ownership stake.

The main alternative to a convertible note is the SAFE (Simple Agreement for Future Equity). While they achieve similar goals, there is a distinct legal difference.

A note is debt. It has a maturity date and an interest rate. This means technically, if you hit the maturity date and haven’t raised more money, the investor could demand repayment and bankrupt the company.

A SAFE is not debt. It has no maturity date and no interest. It is generally friendlier to founders because it removes the pressure of the repayment deadline. However, many traditional investors still prefer notes because the debt structure offers them more legal protection in a downside scenario.

Convertible notes are best used when speed is essential. A priced equity round requires extensive legal paperwork, board approvals, and high legal fees. A convertible note can often be closed in a few days with minimal cost.

They are ideal for “Friends and Family” rounds where the amounts are small and the valuation is unknown. They are also useful for “Bridge Rounds” where a company needs a quick injection of cash to survive between two major financing events.

Founders must be careful, however. Stacking multiple convertible notes with different caps can create a “debt overhang” that makes the capitalization table messy and difficult to calculate. You need to model out exactly how much of the company you are giving away before you sign the paper.