Convertible Note
Also known as Convertible Debt, Convertible Promissory Note, Conv Note
A convertible note is short-term debt that converts into equity at the next priced round, usually at a discount to the round price and capped by a maximum conversion valuation. Interest accrues, a maturity date sets a fallback, and the note holder receives shares of the new preferred series on conversion.
Formula
Conversion Price = min( Round Price * (1 - Discount), Cap / Pre-Money FD Shares )- Round Price
- Price per share paid by new investors in the priced round
- Discount
- Conversion discount (typically 15-25%)
- Cap
- Valuation cap negotiated when the note was issued
- Pre-Money FD Shares
- Fully diluted share count immediately before the priced round
In depth
A convertible note is a loan that the company expects to repay in equity rather than cash. The investor wires money today, the company issues a promissory note with an interest rate (typically 4-8%) and a maturity date (12-24 months), and both sides agree that when the next priced round closes, the principal plus accrued interest converts into shares of the new preferred series.
Two clauses do the real work. The discount gives the note holder a 15-25% break on the price per share, compensating for the earlier risk. The valuation cap sets a ceiling on the company valuation used to compute the note holder's conversion price, so a breakout round does not push the note holder's effective ownership down to a sliver. The two operate in the alternative: whichever produces the lower conversion price wins.
Maturity is the soft constraint. If no priced round closes before the maturity date, the note technically defaults, but founders almost always renegotiate. A defaulted note that demands repayment can sink the company, and the note holders rarely want that outcome.
Why it matters
Convertible notes solved a problem in the late 2000s: how to price a seed-stage company that does not yet have the data to justify a priced round. By punting the valuation question to the next round, both sides skip a hard negotiation and get capital deployed quickly. The trade is that founders accept some dilution math they cannot see clearly until conversion, and investors accept the possibility that the next round prices well above the cap.
The structure has aged because of SAFEs, which strip the debt features. Convertible notes still appear in bridges, jurisdictions where SAFEs are not recognized, and rounds where the investor wants downside protection from accrued interest and maturity.
Worked example
A founder raises $500K on a convertible note with a 20% discount and a $5M valuation cap. Eighteen months later the company closes a Series A at a $20M pre-money valuation, $1.00 per share, with 20M fully diluted shares outstanding pre-money.
Discount conversion price = $1.00 * (1 - 0.20) = $0.80 per share
Cap conversion price = $5M / 20M shares = $0.25 per share
Conversion price = min($0.80, $0.25) = $0.25 per share
Note balance at conversion = $500K + 6% * 1.5y interest ≈ $545K
Shares issued = $545K / $0.25 = 2,180,000 shares
Note holder ownership = 2.18M / (22.18M FD post) ≈ 9.8%
The cap controls the outcome, not the discount. The same $500K would have bought roughly 2.7% if it had entered as new money at the Series A price, so the cap delivered a 3.6x boost in ownership relative to a straight investment at the round price.
Frequently asked
How is a convertible note different from a SAFE?
A convertible note is debt: it accrues interest, has a maturity date, and can default if not converted or repaid. A SAFE is not debt: no interest, no maturity, no repayment obligation. Both convert at the next priced round on similar cap and discount terms, but the SAFE simplifies the legal mechanics.
What is a typical valuation cap and discount?
Cooley reports typical conversion discounts of 15-25%, with valuation caps negotiated based on round size and traction. Cap and discount usually operate in the alternative: the note holder gets whichever produces the lower conversion price.
What happens if a convertible note hits maturity without a qualified financing?
Most notes specify one of three outcomes: extend maturity, convert at a default valuation (often the cap), or repay principal plus accrued interest. In practice, founders renegotiate with note holders rather than trigger default, since insolvency hurts everyone.
Do convertible notes count as debt on the cap table?
They are debt on the balance sheet until conversion, then become equity. Some founders forget that means lenders rank ahead of equity in a liquidation, which matters in a fire sale where the note has not converted. Cap tables typically show notes as a separate line with the as-converted share estimate.