A convertible note is a short-term loan that converts into equity during a future funding round. Key terms include the valuation cap, which sets a maximum conversion price, and a discount rate. While useful, convertible notes have been largely replaced by SAFEs (Simple Agreements for Future Equity) in early-stage US tech startups because SAFEs are not debt and have simpler terms.
Key takeaways
- A convertible note is debt that converts to equity at a future priced round.
- The valuation cap and discount rate reward early investors; they get the better of the two, not both.
- Model the dilution from your valuation cap. A low cap is the most common and costly mistake.
- For most US tech startups, the post-money SAFE is now the standard, not the convertible note.
- Never sign a note without understanding what happens at maturity if you don't raise more money.
- Always use standard documents (from Clerky or Stripe Atlas) and have experienced legal counsel review them.
A convertible note is a loan from an investor that converts into equity at your next funding round. An investor gives you cash now. Instead of being repaid the loan in cash, they get shares in your company later. The price they pay for those shares is determined by the terms of the note and the valuation of your next round.
The entire purpose of a note is to raise money quickly by deferring the difficult conversation about your startup's valuation. If you don't have the metrics for a priced equity round, a note lets you get capital in the bank and start building.
These four terms define how the note works. The valuation cap and discount are the most heavily negotiated.
The valuation cap sets the maximum price your note investors will pay for their equity. They are "capped" at this valuation, protecting them if your company's value skyrockets. This is their primary reward for taking a risk on you when nobody else would.
Founder goal: As high as realistically possible. A low cap causes excessive dilution.
Investor goal: As low as realistically possible. A lower cap means they get more equity for their money.
The discount is a more straightforward reward. It gives the investor a percentage discount on the share price paid by the new investors in your next round.
How it works: If your Series A investors pay $4.00 per share and your note has a 20% discount, the noteholders would convert their investment at a price of $3.20 per share ($4.00 (1 - 0.20)).
Because a convertible note is legally debt, it accrues interest. This interest is almost never paid in cash. Instead, the accrued interest gets added to the principal investment and the total amount converts to equity.
Typical terms: 2% - 8% per year. Higher rates are a red flag.
This is the date the loan is due, creating a deadline to raise a priced round (a "Qualified Financing"). If you reach this date, the noteholders have a few options: extend the date, convert at the cap, or (rarely) demand cash repayment.
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Frequently asked questions
- What is a typical valuation cap for a pre-seed round?
- For a US pre-seed or seed round, typical valuation caps range from $5M to $15M. The specific cap depends on your team, traction, market, and the total amount you're raising.
- Should I use a convertible note or a SAFE?
- Most early-stage US tech startups should use a post-money SAFE. They are simpler, more founder-friendly, and not considered debt. Use a convertible note only if a key investor specifically requires it.
- What happens if I can't raise a funding round before the note's maturity date?
- Typically, you and your investors will agree to extend the maturity date. Less commonly, the note might convert into equity at the valuation cap, or investors could (in theory) demand repayment, though this is rare as it can bankrupt the company.
- Do investors get both the valuation cap and the discount?
- No. The investor benefits from whichever of the two terms gives them a lower share price. They do not get to apply both.
