Convertible Note

Definition: A short-term loan from investors to a startup that converts into equity at a future financing round, usually at a discount or capped valuation, rather than being repaid in cash.

How It Works

The Basic Mechanics

Investors lend cash now and receive shares later instead of negotiating a valuation immediately; the note accrues interest, typically 2–8% annually, until it converts
Legally, a convertible note is debt: it has a maturity date, an interest rate, and — unlike a SAFE (Simple Agreement for Future Equity) — technically must eventually be repaid or converted, giving the holder creditor status if the company fails
Conversion is usually triggered automatically when the company raises a subsequent “qualified financing” round above a pre-agreed minimum size
If no qualifying round happens before maturity, the note may convert at the cap anyway, get extended, or in rare cases get repaid in cash, depending on what the note’s terms specify

The Valuation Cap

A cap sets the maximum valuation used for conversion, protecting early investors if the company’s value rises sharply before the next priced round
Without a cap, an investor who took outsized early risk would convert at the same price as a much later, lower-risk investor, which most early note holders would consider unfair given how much riskier their capital was
The cap effectively guarantees the note holder a minimum ownership percentage for a given investment size, regardless of how high the priced round’s valuation ends up being
Later-stage or “bridge” notes, raised between two already-priced rounds, sometimes skip the cap entirely if the timeline to the next round is short and valuation is less uncertain

The Discount Rate

A discount (commonly 10–25%) gives note holders a lower effective share price than new investors in the priced round, as compensation for having taken on risk earlier
Discounts and caps can both be present on the same note; when they are, the note converts at whichever mechanism gives the investor the better (lower) price
A discount alone, without a cap, still leaves early investors exposed if the company’s valuation rises dramatically, since a fixed percentage off an enormous number is still a very high price per share
Some notes include neither a cap nor a discount, particularly for insider bridge rounds where existing shareholders aren’t trying to negotiate favorable terms against themselves
Investors sometimes accept a lower cap in exchange for a smaller discount, or vice versa, treating the two levers as roughly interchangeable during negotiation

Most-Favored-Nation (MFN) Clauses

An MFN clause gives an earlier note holder the right to automatically upgrade to better terms if the company issues a later note with a lower cap or bigger discount
This protects early, higher-risk investors from being undercut by later investors who negotiate more aggressive terms shortly afterward
Founders raising a note stack in several tranches need to track MFN rights carefully, since a single generous term offered late in the stack can silently reprice every earlier note that carries an MFN clause
MFN clauses typically expire once the company closes its next priced equity round, after which the notes convert under their original (or upgraded) terms
Not every note includes an MFN clause; investors with more negotiating leverage are more likely to insist on one
Founders sometimes cap MFN protection to a defined window (for example, only notes issued within six months) to avoid indefinitely reopening already-closed terms

What Happens at Maturity

Every note has a maturity date, commonly 18–24 months out, by which it must either convert, get repaid, or get extended
If no qualifying financing has happened by maturity, many notes are structured to convert automatically at the cap, treating maturity itself as a conversion trigger
Some investors instead have the right to demand cash repayment at maturity, which can create a serious liquidity problem for a startup that hasn’t raised its next round yet
In practice, most maturing notes are extended by mutual agreement rather than forced to convert or repay, especially when the investor and founder relationship remains healthy
A wave of maturing notes with no clear path to a next round is a warning sign worth addressing well before the deadline, not after it arrives
Some founders proactively renegotiate maturing notes into a fresh instrument with updated terms rather than waiting for the deadline to force an awkward conversation

Convertible Note vs. SAFE

	Convertible Note	SAFE
Legal form	Debt	Not debt — a standalone contract for future equity
Interest	Accrues, adds to conversion amount	None
Maturity date	Yes, creates repayment/conversion deadline	No
Investor downside if company fails	Creditor claim, ranks above equity	No claim above other equity-like holders
Legal complexity/cost	Higher, more negotiated terms	Lower, standardized templates
Typical use today	Bridges, friends-and-family, some seed rounds	Most US pre-seed and seed rounds

Key Terms to Negotiate

Term	Typical Range	Why It Matters
Valuation cap	Varies widely by stage and traction	Sets the maximum conversion price, protecting early upside
Discount rate	10–25%	Rewards early risk relative to the priced round’s investors
Interest rate	2–8% annually	Adds to the principal that ultimately converts into shares
Maturity date	18–24 months	Creates a deadline forcing conversion, extension, or repayment
MFN clause	Present or absent	Protects early note holders from being undercut by later terms
Qualified financing threshold	Often $1M+	Defines the minimum round size that triggers automatic conversion

The Conversion Formula

At conversion, the note holder’s shares are calculated using whichever price is lower — the capped price or the discounted price:

\text{Conversion Price} = \min\left(\frac{\text{Valuation Cap}}{\text{Fully Diluted Shares}}, \ \text{Price Per Share} \times (1 - \text{Discount})\right)

\text{Shares Issued} = \frac{\text{Principal} + \text{Accrued Interest}}{\text{Conversion Price}}

Worked example: A startup raises $300K via a convertible note with a $6M cap and a 20% discount. A year later, its Series A prices the company at a $10M pre-money valuation with a $5 per-share price.

Cap-based price: $6M ÷ the Series A’s fully diluted share count works out to roughly $3.00 per share
Discount-based price: $5.00 × (1 − 0.20) = $4.00 per share
Since $3.00 is lower, the note converts at the cap, meaning the note holder buys in as if the company were valued at $6M rather than $10M — receiving significantly more shares for the same $300K than a new Series A investor does

A Multi-Note Stack in Practice

Founders rarely raise a single note; more often they raise several in sequence as traction builds, each with its own terms:

Note	Amount	Cap	Discount	Effective Price vs. Series A
Note 1 (earliest)	$150K	$4M	20%	Lowest — converts at the cap
Note 2	$200K	$6M	20%	Low — converts at the cap
Note 3 (latest, pre-Series A)	$250K	$9M	15%	Closer to Series A price

Each note converts independently using its own cap and discount, which means the earliest, riskiest capital ends up buying the most shares per dollar — exactly as intended, but also exactly why founders need to model the full stack, not just the most recent note, before estimating post-round dilution.

Why It Matters

Lets founders raise money quickly without the time and legal cost of pricing the company, which is especially useful at the earliest, most uncertain stage
Delays the hardest valuation conversation until the company has more traction and data to support a higher number, benefiting founders if the business is growing
Gives early investors meaningful upside protection through the cap and discount, which is what makes them willing to invest before there’s much to price
Because terms are relatively standardized, notes can close faster than a fully negotiated priced round, which matters when a startup needs cash urgently
Stacking multiple notes across several small checks (a common “bridge” pattern) lets founders raise incrementally rather than needing one large round all at once
The interest that accrues, while modest, compounds the ultimate share count note holders receive, which founders should factor into dilution estimates rather than only counting principal
Because it’s technically debt, an unconverted note remains a liability on the balance sheet and a legal repayment obligation if the company never raises a qualifying round
Multiple notes with different caps and terms, raised at different times, can create a confusing stack that founders must model carefully before a priced round to understand true dilution

Common Pitfalls

Stacking too many notes with different caps and discounts: each one converts on its own terms, and modeling the combined dilution across a messy stack is far harder than founders expect until they actually run the numbers
Ignoring accrued interest when estimating dilution: interest adds to the amount converting into shares, so a note left outstanding for two or three years converts more shares than the original principal alone would suggest
Setting the cap too low: an aggressively low cap to close the round quickly can hand away more ownership than a founder intended once the company’s value grows past what anyone expected
Letting notes reach maturity without a plan: an unconverted, matured note technically becomes due and payable, which can create an awkward legal and cash-flow problem if the company isn’t ready to repay or extend it
Not modeling the option pool alongside the note stack: a pool refresh combined with note conversions can compound dilution far beyond what either change looks like in isolation
Treating a note as “not real equity yet”: founders sometimes underweight how much ownership notes represent simply because no shares have technically been issued, which distorts early cap table planning
Failing to disclose the full note stack to new investors: a priced round’s investors need to know exactly what will convert alongside their investment, since it directly affects their own resulting ownership percentage

Pre-Money vs. Post-Money Caps

A pre-money cap values the company before the note itself is counted, meaning the note holder’s conversion math ignores the dilution their own investment causes
A post-money cap values the company including the money raised across the entire note round, giving investors a precise, guaranteed ownership percentage regardless of how much total capital the company raises on notes
Post-money caps became the more common convention as the SAFE format popularized them, since they let an investor calculate their exact resulting ownership at the time they invest rather than after every other note in the round is known
The distinction matters most when a company raises from many small investors across a long note round, since a pre-money cap’s effective dilution keeps shifting as more notes are added
Founders should always clarify which convention a note uses before agreeing to a headline cap number, since the same $5M cap means meaningfully different things under each convention
Lawyers and cap table software typically flag which convention applies, but founders negotiating directly with an angel investor should confirm it explicitly rather than assume

Negotiating a Convertible Note as a Founder

Push back on caps that feel low relative to genuine traction and comparable deals, since a cap set too conservatively hands away more ownership than the risk being compensated for
Keep the note stack as simple as possible — fewer distinct terms across fewer instruments makes the eventual conversion math easier to explain to a lead Series A investor
Negotiate a longer maturity date if the timeline to the next round is uncertain, to avoid an awkward renegotiation or repayment conversation later
Be transparent with every note holder about the size and terms of the full stack, since investors dislike surprises about dilution discovered only at the priced round
Model the fully diluted cap table under several future valuation scenarios before signing, so the cap and discount’s real impact is understood in dollar terms, not just as abstract percentages
Loop in a startup-experienced lawyer even for a “simple” note, since boilerplate terms still carry real legal and financial consequences
Track the qualified financing threshold carefully, since setting it too high can leave a note stranded without a clear conversion trigger if the next round comes in smaller than expected

When Convertible Notes Are Used

Pre-seed and seed rounds, when a company has too little data to support a credible priced valuation
Bridge financing between two priced rounds, when a company needs a smaller, faster injection of cash to extend runway until the next larger raise
Friends-and-family rounds, where speed and simplicity matter more than heavily negotiated terms
Accelerator and incubator investments, which frequently use a standardized note or SAFE template as a condition of the program
Insider-led rounds, where existing investors extend more capital to a portfolio company without the overhead of a full new priced round
Emergency runway extensions, when a company needs cash quickly and doesn’t have time to run a full priced-round process
International or cross-border deals, where a simple debt instrument can be easier to execute than a jurisdiction-specific equity structure
Convertible debt from strategic partners, such as a larger company investing alongside a commercial partnership, where speed of close matters more than a fully negotiated equity round

Example

A startup raises $300K via convertible notes with a $6M cap and a 20% discount, split across three angel investors who each put in $100K over a few months of quick, informal closes. Fourteen months later, the company has grown enough traction to raise a proper Series A, and a lead venture fund offers a term sheet pricing the company at a $10M pre-money valuation. Because $300K in notes has been accruing 6% annual interest, the actual converting amount is closer to $321K by the time the round closes. Running the conversion math, the note holders convert at the $6M cap rather than the discounted price, since the cap produces the lower, more favorable price per share for them — meaning their $321K buys in as if the company were still worth $6M, even though new Series A investors are paying based on $10M.

The founders, who modeled this scenario months in advance using their cap table software, aren’t surprised by the resulting dilution; they had already accounted for exactly this outcome when they decided how large a Series A round to raise and how much additional dilution the company could absorb. When the lead investor’s lawyers ask for the full note stack during diligence, the founders hand over a clean summary showing all three notes, their accrued interest, and the resulting conversion shares — a five-minute conversation instead of the weeks-long reconciliation headache it becomes for founders who never modeled their stack until the round was already underway.

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