What it means
A convertible note sits in a useful spot between debt and equity. On paper it is a loan with a principal amount, an interest rate and a maturity date, but nobody involved really expects it to be repaid in cash.
Its purpose is to buy time, postponing the hard question of what the company is worth until a later, larger round sets the price. Founders like notes because they are quick and cheap to document, and because they avoid an argument about valuation at the exact moment the business has the least evidence to support one.
Early investors accept them because the conversion terms compensate them for taking the risk earlier than everyone else. Both sides are effectively agreeing to let the next round of investors do the pricing.
Two terms do most of the work. The discount gives the note holder a percentage reduction on the share price paid in the next round, commonly somewhere between 10% and 25%.
The valuation cap sets a maximum company valuation at which the note will convert, so that if the business does spectacularly well, the early money still buys a meaningful stake. Interest accrues on the principal in the normal way, but it is almost always paid in shares rather than cash.
At conversion, the accrued interest is added to the principal and the whole amount is divided by the conversion price to work out how many shares the holder receives. This is why a note that looked small at signing can convert into a larger holding than founders expected.
The nuance that catches people out is that a note is genuinely debt until it converts. If the company never raises a priced round and the maturity date arrives, the holder can in principle demand repayment, which a cash-hungry startup usually cannot manage.
In practice the note is extended or converted by negotiation, but the legal position gives the investor real bargaining power.
In practice
Real-world examples.
Example
A two-person software company needs $300,000 to finish its first product and cannot agree a valuation with its lead angel investor. They sign a convertible note with a 20% discount and an 18-month maturity, and the money lands in the bank within a fortnight rather than after a two-month negotiation.
Example
A food manufacturing startup raises $750,000 across four notes with different caps, written over eighteen months as the business improved. When the priced round finally happens, the finance director builds a conversion schedule showing each note converting at a different price per share, and total dilution comes to 19% rather than the 12% the founders had assumed.
Example
A hardware business reaches the maturity date on a $200,000 note without having raised a priced round. The investor agrees to extend for another year in exchange for the cap being lowered, which increases the number of shares the note will eventually buy.
Think of it
“Convertible note is a loan that becomes ownership-debt that converts to stock later.
Formula
Calculation
Conversion amount = Principal + Accrued interest
Conversion price = the lower of (Priced round share price x (1 - Discount)) and (Valuation cap / Fully diluted shares before the round)
Shares issued = Conversion amount / Conversion price
An investor lends $450,000 on a convertible note carrying 6% simple interest, a 20% discount and a $9,000,000 valuation cap. Two years later the company raises a priced round at $2.00 per share, with 6,000,000 shares outstanding before the new money.
Accrued interest = $450,000 x 6% x 2 years = $54,000
Conversion amount = $450,000 + $54,000 = $504,000
Discount price = $2.00 x (1 - 0.20) = $1.60 per share
Cap price = $9,000,000 / 6,000,000 shares = $1.50 per share
The note converts at the lower figure, $1.50.
Shares issued = $504,000 / $1.50 = 336,000 shares
Had the note converted at the full round price of $2.00, the investor would have received only 252,000 shares, so the cap and discount together are worth an extra 84,000 shares.Case study
Seen in the real world.
The following is an illustrative, fictional example. Larkfield Robotics, an invented company, raised $600,000 on convertible notes from six angel investors over its first two years. The founders treated the notes as "free money until later" and did not model what conversion would look like, partly because the notes never appeared as equity on any of their internal ownership spreadsheets.
When a venture fund offered to lead a priced round eighteen months later, the fund's lawyers produced a capitalisation table showing the notes converting into 21% of the company before the new investment. The two founders, who believed they still held 80% between them, discovered they would drop to just under 50% once the new round closed.
The deal still completed, but the founders spent three weeks renegotiating an option pool they had assumed was already agreed. The lesson in this fictional case is simple: a convertible note is dilution that has already happened, it is just waiting for a trigger to show up.
Watch out
Common mistakes.
- Treating a convertible note as if it were an equity investment that has already been priced, and ignoring it when calculating current ownership percentages.
- Forgetting that accrued interest converts into shares too, which understates the eventual dilution by several percentage points on a multi-year note.
- Signing several notes with different caps and discounts without modelling the combined effect, then being surprised by the blended dilution at the priced round.
Questions
People also ask.
What happens if the company never raises a priced round?
The note either matures and becomes repayable, gets extended by agreement, or converts at a pre-agreed fallback valuation written into the document.
Is a convertible note better than a SAFE?
A SAFE is simpler and carries no interest or maturity date, while a note gives the investor the protections of being a creditor, so the choice depends on how much comfort the investor needs.
Does the interest have to be paid in cash?
Almost never in practice, because the standard drafting rolls accrued interest into the conversion amount and settles it in shares.
From the founder's library
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