Contents:
- The Short Answer
- Why Startups Use Convertible Notes
- How the Mechanics Work
- The Discount Rate
- The Valuation Cap
- Interest Rate
- An Expert’s Take
- A Real Example
- Putting This Into Context
- Frequently Asked Questions
- Is a convertible note the same as a SAFE?
- What happens if a startup never raises another round?
- Do convertible notes hurt a founder’s ownership?
- Are convertible notes risky for investors?
Imagine you and a friend agree to lend a neighbor $5,000 for a home renovation, with a deal that instead of paying you back in cash, they’ll give you a stake in the house once it’s appraised and sold. That’s roughly the logic behind a convertible note, just applied to a startup instead of a house.
The Short Answer
A convertible note is a short-term loan that converts into equity, usually during a startup’s next funding round, instead of being repaid in cash. Investors lend money now and receive shares later, typically at a discount to the price new investors pay in that future round.
Why Startups Use Convertible Notes
Early-stage startups are hard to value accurately. A convertible note lets a founder raise money quickly without having to agree on a specific company valuation upfront, which can save months of negotiation. The valuation gets settled later, when there’s more data to work with, like revenue or user growth.
How the Mechanics Work
The Discount Rate
Most convertible notes include a discount rate, commonly 15-25%, giving early investors a lower price per share than investors in the priced round that triggers conversion. This rewards early investors for taking on more risk.
The Valuation Cap
A valuation cap sets a maximum company value for conversion purposes, protecting early investors from being diluted if the company’s value skyrockets before the note converts. A $5 million cap means the investor converts as if the company were worth no more than $5 million, even if the actual round prices the company at $10 million.
Interest Rate
Convertible notes typically carry a modest interest rate, often 2-8% annually, which accrues and gets added to the amount that eventually converts into equity, rather than being paid out in cash.
An Expert’s Take
“Founders often treat the valuation cap as a minor detail, but it’s usually the single term that determines how much of the company they’ll own after conversion,” says Marcus Feldman, a startup attorney and adjunct lecturer on venture finance at a Boston-area business school. “I tell every founder to model out three different valuation scenarios before signing.”
A Real Example
A friend of mine raised $150,000 through a convertible note with a $4 million cap and a 20% discount. When her Series A priced the company at $8 million eighteen months later, her early investors converted as though the company were worth $4 million, roughly doubling their effective ownership compared to new Series A investors paying full price.
Putting This Into Context
Convertible notes remain most common in pre-seed and seed rounds, where speed and simplicity outweigh the need for a precise valuation. Once a startup has meaningful revenue or a clear market position, priced equity rounds typically take over because both sides have enough information to negotiate a fair valuation directly.
Frequently Asked Questions
Is a convertible note the same as a SAFE?
No. A SAFE, or Simple Agreement for Future Equity, works similarly but isn’t technically debt and carries no interest rate or maturity date, unlike a convertible note.
What happens if a startup never raises another round?
Terms vary, but many notes include a maturity date, often 18-24 months, after which the note may convert at a set valuation, get repaid, or be renegotiated.
Do convertible notes hurt a founder’s ownership?
They can, especially with a low valuation cap, since early investors convert at a discount that dilutes the founder’s percentage more than a straightforward priced round might.
Are convertible notes risky for investors?
Yes, since the startup could fail before the note ever converts, making the loan effectively worthless despite the accrued interest on paper.
