The Basics of Convertible Notes Explained

The Basics of Convertible Notes Explained reveal why this funding instrument has become the lifeblood of early-stage venture capital in 2025.

It allows startups to secure necessary cash quickly without immediately determining a valuation, a process that is often time-consuming and contentious. Convertible notes are essentially short-term loans.

These notes are structured to convert into equity at a later date, typically during the company’s first major priced funding round.

They offer both speed and flexibility, which are critical when securing seed capital to fund initial growth and product development.

What is a Convertible Note and How Does It Function?

A convertible note is a form of debt that converts into equity under specific conditions, most often when the company raises a qualified financing round. Think of it as a delayed stock purchase agreement.

It provides the investor with an immediate return in the form of interest, but the primary return is realized only upon the conversion into shares.

This structure postpones the difficult valuation discussion until the business has more verifiable metrics.

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How Does Conversion Address Early Valuation Challenges?

Valuing a pre-revenue, high-growth startup is inherently speculative and subjective. Convertible notes bypass this conflict by deferring the valuation until a subsequent professional investor sets the price.

This deferral speeds up the negotiation process significantly. It ensures the startup can focus on milestones, not on arguing about phantom future worth.

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What Happens If the Company Fails Before Conversion?

Since a convertible note is initially debt, investors hold a crucial advantage if the company liquidates early. They stand higher in the repayment hierarchy than common shareholders.

This debt feature provides a basic level of downside protection for early investors, making the investment more palatable despite the high risk of startup failure.

Read more: When to Seek Capital and When to Wait

When Does Conversion Usually Take Place?

Conversion is typically triggered by a “Qualified Financing,” defined as an equity round raising a minimum specified amount of capital (e.g., $2 million). This signals external validation of the company’s value.

The note converts at a price related to the new investors’ price, but with certain adjustments designed to reward the initial, riskier investment.

Why Do Investors Demand Discount Rates and Valuation Caps?

Investors taking the early risk demand compensation for their capital commitment before the company’s value is proven.

This compensation is primarily structured through a Discount Rate and a Valuation Cap. These are the critical terms defining the Basics of Convertible Notes Explained.

These mechanisms ensure that the early investor receives their future equity at a more favorable price than the incoming subsequent investors. They serve as a premium for taking on uncertainty.

What is the Purpose of the Discount Rate?

The discount rate (typically 15% to 25%) allows the note holder to purchase equity at a reduced price compared to the investors in the future Qualified Financing round.

For example, a 20% discount means they buy shares for 80% of the price.

This discount rewards the investor for the illiquidity and the high risk associated with providing capital in the earliest stages. It guarantees immediate financial advantage upon conversion.

How Does the Valuation Cap Protect Early Investors?

The valuation cap is the maximum valuation at which the investor’s note can convert into equity. If the company’s valuation in the Qualified Financing exceeds this cap, the early investor converts at the cap price.

The cap acts as a “bonus” if the startup experiences explosive growth. It ensures that early believers benefit greatly from a high-priced subsequent round.

Applying the Cap and Discount

Imagine a $5M Cap and a 20% Discount. If the next round values the company at $10M, the note holder converts at the $5M Cap (the lowest valuation).

If the next round is only $4M, the note holder converts at 80% of $4M, or $3.2M (the discount).

The investor effectively chooses the better deal between the cap and the discount, maximizing their ownership stake. This dual protection is central to the Basics of Convertible Notes Explained.

What Are the Key Non-Conversion Terms to Understand?

Beyond the cap and discount, a convertible note includes standard debt terms that define the basic financial relationship between the company and the investor.

These provisions are legally important and govern scenarios outside of successful equity financing.

Understanding these non-conversion terms is vital, as they manage the investor’s rights if the startup trajectory changes or the funding milestones are not met. They protect the investor in unfavorable scenarios.

What Is the Significance of the Maturity Date?

The maturity date is the point at which the debt becomes due. If the note has not converted by this date (i.e., no Qualified Financing has occurred), the company must repay the investor the principal plus accrued interest.

This repayment obligation forces the startup to prioritize raising equity or face bankruptcy. However, this date is often negotiated and can be extended.

What Happens When Interest Accrues on the Note?

Convertible notes typically accrue simple annual interest (usually 3% to 7%). This interest is rarely paid in cash; instead, it is added to the principal amount.

The total accrued principal and interest are what ultimately converts into equity. The investor thus gets a larger stake in the company due to this accrued interest.

The Acquisition Scenario

If the company is acquired for cash before a Qualified Financing, the note terms typically stipulate an accelerated repayment or conversion.

Often, the investor receives a multiple (e.g., 1.5x to 2x) of their principal investment back.

This “liquidity preference” clause ensures that the early investor receives a significant return even if they never officially converted into shares.

Why Have Convertible Notes Fallen Out of Favor Recently?

While historically popular, convertible notes have seen increased competition from newer, cleaner instruments like the SAFE (Simple Agreement for Future Equity).

The hybrid debt-equity nature of notes introduces complexities that many founders and investors now prefer to avoid.

The debt features, particularly the maturity date and interest, necessitate compliance and create potential liabilities that are often unnecessary for early-stage investing. The SAFE simplifies the entire transaction significantly.

How Does the SAFE Agreement Differ from the Note?

A SAFE is technically not debt; it is a warrant to purchase stock in the future. It has no maturity date and does not accrue interest. This eliminates the risk of an unexpected repayment obligation or bankruptcy concerns.

The SAFE is seen as less adversarial and cleaner, reducing legal costs and time. It focuses purely on the equity conversion terms.

Why is the Debt Component Sometimes Problematic?

The debt component of notes can complicate a startup’s balance sheet, particularly when approaching later-stage investors or bank financing. The presence of existing debt requires complex accounting.

Furthermore, a defaulting note at maturity can lead to complex and costly restructuring negotiations, or even force a sale of the company risks avoided with equity-based instruments.

Data aggregated by Cooley LLP on U.S. seed funding rounds indicates that by Q3 2024, over 80% of early-stage (seed) funding utilized the SAFE structure, with convertible notes making up less than 15%. This clearly shows the market shift away from debt instruments.

Convertible Note Feature	Primary Purpose	Benefit to Investor	Potential Drawback for Founder
Debt Status	Provides Downside Protection	Higher priority claim in liquidation	Potential Obligation for Cash Repayment at Maturity
Discount Rate	Rewards Early Risk-Taking	Converts to Equity at a Lower Price	Immediate Dilution is Greater than New Investors
Valuation Cap	Protects Against Valuation Risk	Guarantees a Minimum Ownership Stake	Limits Upside/Value Retention if Company Explodes
Maturity Date	Forces an Equity Raise Timeline	Provides a Repayment Trigger	Risk of Default/Forced Company Sale
Interest Rate	Compensation for Time Value of Money	Adds to the Principal that Converts	Increases Conversion Principal/Total Dilution

Conclusion: Understanding the Right Tool for the Job

The Basics of Convertible Notes Explained reveal them as a sophisticated, time-tested tool for rapidly securing seed funding while deferring valuation.

Their hybrid debt-equity structure offers critical downside protection for early investors, making the risk palatable.

However, the market is evolving, favoring simpler, equity-only instruments like the SAFE.

Entrepreneurs must understand the distinct pros and cons of notes versus SAFEs to choose the funding structure that best supports their company’s risk profile and growth trajectory.

Are you prepared to choose the funding instrument that optimizes your company’s long-term capitalization strategy? Share your experiences and questions about valuation deferral in the comments!

Frequently Asked Questions

Are convertible notes standardized like SAFEs?

No. Unlike the SAFE, which is highly standardized by Y Combinator, convertible notes are generally bespoke debt agreements. This means they require higher legal fees and more negotiation time.

Can convertible notes be used in later funding rounds?

While possible, they are rare after the seed stage. Later rounds (Series A, B) typically involve a “priced round” where the valuation is set immediately, making notes unnecessary.

What is the biggest advantage of using a convertible note for founders?

The biggest advantage is the speed of closing. Since the valuation is deferred, entrepreneurs can get capital in weeks instead of months, accelerating initial growth efforts immediately.

What is “dilution” in the context of convertible notes?

Dilution occurs when the note converts into equity, giving investors a share of the company. The earlier the cap or the higher the discount, the greater the dilution of the founder’s original ownership percentage.

Why do investors prefer the debt structure sometimes?

The debt structure provides a legal safety net. In the worst-case scenario (liquidation), note holders get paid back before equity holders, offering better recovery potential than a SAFE holder.