Convertible Note
A short-term debt instrument that converts to equity at a future funding round, typically with an interest rate, maturity date, discount, and valuation cap.
A convertible note is a short-term loan that converts into equity (typically preferred stock) at a future financing event, rather than being repaid in cash. It is one of the oldest startup financing instruments, predating the SAFE note, and is still widely used in some markets and geographies where SAFE notes are less accepted.
As a debt instrument, a convertible note has terms that SAFEs lack: an interest rate (typically 4–8% annually, often accruing non-cash and adding to the principal at conversion), a maturity date (typically 18–24 months, at which point repayment or conversion becomes due if no priced round has occurred), and security provisions specifying lender rights in default.
Like SAFEs, convertible notes typically include a discount rate (10–20%) and/or a valuation cap, entitling noteholders to convert at a more favorable price than new investors in the qualifying financing round. At a priced round, the accrued principal plus interest converts to equity using whichever conversion mechanism provides the most shares.
The maturity date is the most significant difference from SAFEs and creates potential tension: if a startup doesn't raise a priced round before the note matures, the investor has the right to demand repayment — cash a startup likely doesn't have. In practice, most notes are extended by mutual agreement, but the maturity creates negotiating leverage for investors and legal complexity.
Convertible notes appear on the balance sheet as debt until conversion, which can affect financial ratios, credit assessments, and debt covenant calculations in ways that SAFEs (classified differently) may not. For accounting purposes, the debt host and embedded conversion feature are typically analyzed separately under ASC 815.
FAQs
Should a startup use a SAFE or convertible note?
SAFEs are simpler, cheaper, and don't create debt or default risk — generally preferred for US pre-seed and seed rounds. Convertible notes may be appropriate when investors require debt treatment for their own fund accounting, when raising in jurisdictions where SAFEs aren't legally established, or when specific deal terms require note structure. Angel investors in some regions still prefer notes.
What happens if a convertible note matures with no priced round?
At maturity, the noteholder can demand repayment (typically impractical for cash-strapped startups), extend the note by mutual agreement, or convert to equity at an agreed valuation. In most cases, notes are extended; the maturity date rarely triggers actual repayment demands if the company is operating and making progress.
Is interest on a convertible note actually paid in cash?
Usually not. Most convertible notes accrue interest non-cash — it accumulates on paper and is added to the principal balance that converts at the qualifying round. Actual cash interest payments would strain startup cash flow and are rare. The interest accrues to slightly increase the number of shares issued at conversion.
Related Terms
SAFE Note
A Simple Agreement for Future Equity — a startup financing instrument that converts to equity at a future priced round, without accruing interest or setting a maturity date.
Priced Round
A funding round in which the company's value is formally determined and investors receive shares at a specific price, establishing a definitive valuation.
Cap Table
A spreadsheet or software record showing all equity ownership in a company, including shares, options, warrants, and convertible instruments.
Dilution
The reduction in existing shareholders' ownership percentage caused by the issuance of new shares to investors, employees, or through conversion of instruments.
