Convertible Notes

What Is a Convertible Note?

A convertible note (also called a convertible loan or bridge note) is a debt instrument that a startup uses to raise early-stage capital without immediately setting a valuation. Unlike traditional debt, a convertible note is not intended to be repaid in cash. Instead, the principal and accrued interest convert into equity at a future priced funding round, usually at a discount to reward the early investor for taking on more risk.

Convertible notes were the dominant early-stage financing instrument before SAFEs became widespread. They remain common in jurisdictions where the legal framework for SAFEs is less established, and in bridge financing situations where a startup needs capital quickly between priced rounds.

Core Terms of a Convertible Note

Principal Amount The amount the investor lends to the startup. This is the starting point for calculating how many shares the investor receives at conversion.

Interest Rate Convertible notes carry an annual interest rate, typically 5–8% for startup notes, though rates vary by market and investor type. Unlike a bank loan where interest is paid periodically, startup convertible notes accrue interest and the accrued interest converts to equity alongside the principal at the conversion event.

Example: A $200K note at 6% annual interest converts after 18 months. The conversion amount is $200K principal + $18K accrued interest = $218K worth of equity.

Maturity Date Convertible notes have a maturity date — typically 12–24 months from issuance. If a qualifying priced round has not occurred by the maturity date, the note becomes due and payable. In practice, most notes are either converted or extended before maturity. However, a maturity date creates pressure and is a risk founders must manage.

Valuation Cap Like a SAFE, most convertible notes include a valuation cap — the maximum pre-money valuation at which the note converts. This protects investors who took on more risk at the earliest stages.

Discount Rate Most convertible notes include a 15–25% discount to the price per share in the next priced round. The investor converts at whichever gives them more shares: the cap calculation or the discount calculation.

Conversion Trigger Events Convertible notes automatically convert upon a qualified financing — a priced equity round above a minimum size threshold (often $500K–$1M). Some notes also include conversion rights upon change of control, IPO, or maturity.

Convertible Note vs SAFE: Key Differences

The core distinction is that a convertible note is debt while a SAFE is not. This has several practical implications:

1. Balance sheet treatment: Convertible notes appear as liabilities on your balance sheet; SAFEs are treated as equity instruments in most accounting frameworks
2. Maturity risk: Notes create a deadline; SAFEs do not expire
3. Interest accrual: Notes compound over time, increasing the conversion amount; SAFEs do not accrue interest
4. Legal complexity: Notes require more documentation and negotiation around interest rate, maturity, and default terms
5. Jurisdiction suitability: In markets where SAFEs lack established legal precedent (including some SEA jurisdictions), convertible notes may be the safer choice

When to Use Convertible Notes

Convertible notes are typically appropriate in three situations:

Bridge Financing: When a startup needs capital to reach the next milestone before a priced round, a note allows quick fundraising without reopening valuation negotiations. Existing investors who know the business well can extend a bridge note in days.

Jurisdiction Constraints: In markets where SAFEs are not well understood by local lawyers or have uncertain tax treatment, convertible notes with established legal precedent provide more certainty.

Strategic Investor Preferences: Some corporate or institutional investors prefer the debt treatment of convertible notes for their own accounting purposes.

Common Mistakes with Convertible Notes

Stacking too many notes: Issuing multiple notes at different caps and discounts without modelling the conversion waterfall creates unexpected dilution at the priced round and confuses incoming investors.

Ignoring maturity dates: Founders who raise notes and focus entirely on growth can find themselves in default when a round does not close before maturity. Always track maturity dates and negotiate extensions proactively.

No conversion floor: Without a minimum priced round size to trigger automatic conversion, a small priced round may not qualify, leaving note holders in debt limbo.

Forgetting accrued interest: The conversion amount includes accrued interest, which can be meaningful on large notes held for 18+ months. Model this before your priced round to avoid surprises.