Convertible notes

What are convertible notes?

A convertible note is a loan that everyone expects will turn into stock. An investor wires money now, the company signs a note promising repayment with interest, and both sides assume the balance will never be paid back in cash. When the startup raises a priced round later, the note converts into shares at a price tied to that round.

The structure exists because pricing an early company is guesswork. Two founders with a prototype and no revenue cannot credibly defend a valuation, and arguing about it burns legal fees. A note defers the question until a lead investor with better information answers it.

Three terms do most of the work. The discount gives noteholders a percentage off the next round's share price as compensation for early risk. The valuation cap sets a ceiling on the valuation used for their conversion, so someone who backed you at the idea stage is not converted at a price that wipes out their upside. The maturity date is when the loan comes due if no qualifying round has happened, and founders forget it most.

How a convertible note converts

Conversion runs on whichever method gives the investor more shares: conversion price = lower of (round price x (1 minus discount)) and (valuation cap / fully diluted shares).

Say an angel puts in $100,000 on a note with a 20% discount, a $5,000,000 cap, and 5% simple interest. Eighteen months later you raise at a $10,000,000 pre-money valuation on 10,000,000 shares, so the round price is $1.00 per share. The discount path prices shares at $0.80; the cap path prices them at $0.50 ($5,000,000 divided by 10,000,000 shares). The cap wins. With interest the balance is about $107,500, which converts into roughly 215,000 shares.

The new investor paying $1.00 gets half as much stock per dollar, and that gap comes out of founder ownership.

Why convertible notes matter for startups

For a team of one to five people, a note is often the difference between closing money this month and closing it next quarter. Documents are short, legal costs are lower than a priced round, and you can take checks as investors commit.

The tradeoff is deferred pain. Notes stay invisible in a simple cap table until they convert, so it is easy to sell 15 percent of the company without feeling it. They are also real debt: if maturity arrives with no round closed, the holder can demand repayment. Most extend instead, but from a weak position. Track your runway against the maturity date, not just your bank balance.

Convertible notes in practice

Imagine you run a two-person scheduling tool. An angel investor offers $150,000 on a note with a $4,000,000 cap so you can hire an engineer. A year later a fund leads a seed round at an $8,000,000 pre-money valuation. The note converts at the cap, so the angel effectively bought in at half the seed price. You gave up more equity than the headline suggested, and you got that engineer a year earlier, which is why the round happened at all.

Typical terms and rules of thumb

Discounts commonly land between 10 percent and 25 percent, with 20 percent the most familiar figure. Interest rates are usually low single digits and exist for legal reasons more than as real return. Maturity is frequently set at 12 to 24 months. Caps vary too much by sector and traction to quote honestly, so negotiate yours against deals your peers have actually signed.

Many teams now use a SAFE instead: similar on conversion, but with no interest and no maturity date.

Common mistakes

• Stacking notes without modeling dilution. Three notes at three caps can quietly hand over a quarter of the company. Run the math before signing each one.
• Treating maturity as theoretical. A note maturing before you raise starts a renegotiation you did not plan for. Give yourself more months than your timeline suggests.
• Setting the cap too high. A cap above what the next round can support looks like a win now and forces a reset later.
• Assuming money replaces traction. A note buys time, not demand. Without real customer validation, it funds a longer walk in the wrong direction.

Notes sit alongside the other early paths founders weigh, from living on revenue through bootstrapping to raising a priced round. Learn the conversion math first: every note you sign is an ownership decision you will not feel until the round after this one.