Convertible notes were the standard early-stage financing instrument before the SAFE existed. They remain common in the Midwest with angel investors and in bridge rounds between priced equity financings. Founders should understand how the four economic levers in a convertible note interact because they are not as independent as they appear.
What a Convertible Note Is
A convertible note is a short-term debt instrument that converts into equity at a later financing event, typically the company’s next priced round. Unlike a SAFE, it is classified as a loan. It has a maturity date, an interest rate, and, if it is not converted, a contractual repayment obligation.
In practice, almost all convertible notes are intended to convert. They are not intended for repayment, even if the notes legally provide the right to be paid out in cash.
The Four Economic Levers
Discount Rate
A discount rate is a percentage off the price per share in the priced round. A 20% discount means the noteholder converts at 80% of the round price.
Valuation Cap
A valuation cap is the maximum valuation at which the note will convert. If the next round prices the company higher than the cap, the noteholder converts as if the round had priced at the cap. A note with a $5 million cap converting into a $20 million round receives shares as if the round had priced at $5 million, creating meaningful upside for the early investor.
Interest Rate
Convertible notes accrue interest until conversion or repayment. At conversion, the accrued interest is typically added to the principal and converted into equity. A $500,000 note with one year of 6% interest converts $530,000 into equity.
Maturity Date
The date by which the note must convert or be repaid. Common maturities are 18 to 24 months. If the company has not raised a priced round before maturity, noteholders technically have the right to demand repayment. In practice, however, investors often extend the note, negotiate revised terms, or accept conversion at a default valuation.
How These Terms Interact
The valuation cap and discount usually both apply, with the investor electing the better outcome at conversion. A note with a $5 million cap and a 20% discount converting into a round priced at $4 million would convert at $4 million × 0.80 = a $3.2 million effective valuation, not the cap. The discount only matters when the next round prices below the cap.
The interest rate is sometimes treated as an afterthought, but on a multi-year note it can materially increase the amount converting into equity. The maturity date is often the most heavily negotiated provision when a note approaches its term without a conversion event.
When a Convertible Note Makes Sense
Convertible notes are still appropriate when investors prefer the protections of a debt instrument, when state or federal law makes SAFEs awkward, or when the financing is genuinely a bridge round with a clear conversion path.
For early-stage technology companies in the United States, SAFEs are usually simpler and less expensive to implement, but a well-structured convertible note can make sense depending on the nature of the business or raise.
If you are evaluating a convertible note round, Avisen Legal’s startup and growth counsel team can help you stress-test the terms, model the cap table, and evaluate the financing’s impact on future venture capital and angel investors rounds before you sign. Get consultation today.
Frequently Asked Questions About Convertible Notes
What is a convertible note?
A convertible note is a debt instrument that converts into equity upon a future financing event, typically a priced funding round. Unlike a SAFE, it includes an interest rate and maturity date.
How does a valuation cap work in a convertible note?
A valuation cap limits the valuation used to calculate the noteholder’s conversion price. If the company raises money at a valuation above the cap, the investor receives shares based on the lower capped valuation.
Why do convertible notes include interest?
Because a convertible note is debt, it accrues interest over time. That accrued interest is usually added to the principal amount and converted into equity when the note converts.
What happens if a convertible note reaches maturity?
When a note reaches maturity before conversion, the parties typically negotiate an extension, amendment, or alternative conversion structure. While repayment may be contractually available, it is often not the preferred outcome for either party.
Are convertible notes still used today?
Yes. Although SAFEs have become more common in many startup financings, convertible notes remain popular for bridge rounds, angel financings, and situations where investors prefer the protections associated with debt instruments.
How do convertible notes differ from SAFEs?
Convertible notes are debt instruments with interest rates and maturity dates. SAFEs are not debt and generally do not include repayment obligations, interest accrual, or maturity dates.
Should founders model dilution before issuing convertible notes?
Absolutely. Founders should understand how valuation caps, discounts, accrued interest, and future financing assumptions affect ownership and dilution before issuing convertible notes.
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