Convertible note
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A form of short-term debt that converts into equity at the next priced funding round, often used in early-stage fundraising.
A convertible note is a loan that converts into equity later. Instead of setting a valuation now (which is hard at the earliest stages), the investor lends money with the agreement that it will convert into shares at the next priced round, usually at a discount.
Convertible notes have key terms: a valuation cap (maximum valuation for conversion), a discount rate (typically 15-25%), an interest rate (usually minimal), and a maturity date (when the note must be repaid or converted). The cap and discount give the investor a better price than later investors as a reward for investing earlier.
SAFEs have largely replaced convertible notes for early-stage fundraising because they are simpler (no interest, no maturity date). But convertible notes are still used, especially when the investor wants the debt protections that SAFEs do not provide. Both instruments appear on the cap table and convert at the next priced round.
Examples
An angel invests via a convertible note.
The angel invests $100K with a $5M valuation cap and a 20% discount. At the Series A ($10M pre-money valuation), the note converts at the lower of: the $5M cap or the Series A price with a 20% discount. The cap gives a better deal, so the note converts at $5M, giving the angel twice the shares they would have gotten at the Series A price.
A convertible note reaches its maturity date.
The note has a 24-month maturity date. The company has not raised a priced round by then. The investor and company negotiate: extend the maturity by 12 months, convert at the cap valuation, or repay the debt. Most investors extend.
A founder compares convertible notes and SAFEs.
Convertible notes: accrue interest, have a maturity date, are legally debt. SAFEs: no interest, no maturity date, are legally equity agreements. The founder chooses SAFEs for simplicity and because most angel investors in their network prefer them.
Frequently asked questions
What is the difference between a convertible note and a SAFE?
A convertible note is debt with interest and a maturity date. A SAFE is not debt: no interest, no maturity date, no obligation to repay. SAFEs are simpler and more founder-friendly. Convertible notes give investors slightly more protection because they are legally debt.
What is a valuation cap on a convertible note?
The maximum valuation at which the note converts to equity. If the cap is $5M and the next round is at $20M, the note converts at $5M, giving the investor 4x more shares than if they had invested at the $20M round price. The cap rewards early risk.
Related terms
A simple investment instrument created by Y Combinator that converts to equity at the next priced funding round.
The estimated worth of a company, determined during a funding round by negotiation between founders and investors.
The first significant round of funding for a startup, typically raising $1-5M to validate the product and find initial customers.
A high-net-worth individual who invests their personal money in early-stage startups in exchange for equity.
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