Understanding the Convertible Note: When to Use It & Why

A convertible note is a short-term debt instrument that automatically converts into equity upon a qualified financing round. For early-stage startups, it offers a flexible bridge between friends-and-family or angel investments and a pricier priced round—combining speed, simplicity, and investor incentives.

1. What Is a Convertible Note?

• Debt that converts: You borrow money today, repayable in cash or, more commonly, converted into preferred shares at the next priced equity round.

• Automatic conversion: Upon a “qualified financing” (e.g. your Series A), the note principal plus accrued interest converts into stock at a discount or capped valuation.

• Bridge financing: Serves as an interim round to fund operations and product development until you can negotiate a full valuation.

2. Key Terms & Mechanics

• Principal — The amount of money raised via the note.

• Interest rate — Interest that accrues on the principal until conversion (typically 4–8% per year).

• Maturity date — The date when the note becomes due if it has not yet converted.

• Discount rate — The percentage discount applied to the price per share at the next financing round (e.g., 20%).

• Valuation cap — The maximum “effective” valuation used to calculate the conversion price for early investors.

• Qualified financing — The minimum-size investor round that triggers automatic conversion.

1. Conversion price is the lower of:

   • Price per share × (1 – discount)

   • Price per share at a valuation cap

2. Maturity: If no qualified round happens by maturity, notes may:

   • Become repayable in cash

   • Automatically convert at a pre-set valuation

   • Extend on mutual consent

3. Advantages & Disadvantages

Advantages for Founders

• Speed & simplicity: Simple docs, little negotiation over valuation.

• Deferred valuation: Postpones tricky valuation discussions until you have traction.

• Investor alignment: Discount and cap reward early believers.

Disadvantages & Risks

• Cap creates pressure: A low cap can lead to heavy dilution if valuation soars.

• Debt on the books: Until conversion, it’s liability—maturity can become a cash-drain.

• Potential misalignment: Aggressive conversion terms may frustrate later investors.

4. When to Use a Convertible Note

1. Pre-product or early-product stage

   • You need runway to build MVP or achieve key milestones.

2. Uncertain valuation

   • Market or metrics aren’t strong enough to support a credible priced round.

3. Fast fundraising need

   • Friends, family, or angels want quick close without lengthy term-sheet negotiations.

4. Bridge to priced round

   • You’re in active talks for a Series A but need interim capital to hit milestones.

When to Avoid

• Later-stage rounds where you have enough data to secure a fair valuation.

• Complex cap tables that can be destabilized by multiple overlapping notes/caps.

• Investors demanding control (notes typically don’t carry board seats or voting rights).

5. Best Practices for Founders

1. Set a reasonable cap: Balance founder dilution and investor upside.

2. Agree on extensions early: Build in clear extension terms to avoid crunch.

3. Limit the number of notes: Too many overlapping caps/discounts complicates your cap table.

4. Document investor rights: Use a simple side letter to clarify pro-rata, information, or governance rights.

5. Communicate with future investors: Ensure your Series A lead is comfortable rolling convertible notes into their round.

A convertible note is a powerful tool for early-stage founders to raise fast, simple, and valuation-deferred capital. Used wisely—with prudent caps, clear terms, and a view toward your next priced round—it can propel you from idea to traction without overcomplicating your cap table or burning precious runway.

Have more questions? Talk to your corporate counsel or startup-focused attorney to tailor convertible-note terms that fit your growth plan.