What is a Convertible Note?

If you’re navigating the world of startup financing, you’ve probably heard about convertible notes. They’re a popular tool for raising funds, especially in the early stages when valuing your company can feel like guesswork. As a founder, understanding convertible notes can give you a leg up in securing flexible and founder-friendly financing. In this guide, I’ll walk you through what they are, how they work, and why they might be a good fit for your startup.

What Is a Convertible Note?

A convertible note is a type of short-term debt that converts into equity in the future, typically during your next funding round. Instead of repaying the loan in cash, the investor receives shares in your company at a discounted price or with a valuation cap. This allows you to delay setting a formal valuation for your company until you have more data or traction.

Key Features of Convertible Notes

Discount Rate

When the note converts to equity, investors typically get a discount (often 10-30%) on the share price in the next funding round. This discount rewards them for taking on early-stage risk.

Valuation Cap

The valuation cap sets the maximum company valuation at which the note converts to equity. It protects early investors by ensuring their shares aren’t diluted too much if your valuation skyrockets during the next round.

Interest Rate

Since a convertible note is technically debt, it accrues interest—usually between 2% and 8% annually. Upon conversion, this interest is often added to the principal amount before converting into equity.

Maturity Date

Convertible notes have a maturity date, usually 12-24 months. By this date, the note must convert into equity or be repaid. In some cases, investors may negotiate for alternative outcomes if a funding round hasn’t occurred by the maturity date.

Why Use Convertible Notes?

Quick and Flexible Financing

Convertible notes are faster to negotiate than traditional equity deals, making them ideal for early-stage startups that need funds quickly.

Avoiding Premature Valuation

Early-stage startups often lack the data needed to justify a valuation. Convertible notes let you raise funds without locking in an undervalued price for your equity.

Attracting Investors

The combination of a valuation cap and discount rate makes convertible notes attractive to investors, giving them upside potential without immediate equity ownership.

Minimal Legal Complexity

Convertible notes require less legal documentation than equity deals, saving you time and legal fees.

Challenges and Risks of Convertible Notes

Potential for Investor Misalignment

If the valuation cap is set too low, early investors might end up with a disproportionately large equity stake, which could lead to friction in future funding rounds.

Maturity Date Risks

If your startup doesn’t raise another round before the note’s maturity date, you may need to renegotiate terms or repay the loan, which can strain your finances.

Dilution Concerns

Convertible notes can lead to unexpected dilution if you raise at a high valuation with a low cap. Be sure to run dilution scenarios to avoid surprises.

How to Structure a Convertible Note

Negotiate Favorable Terms

• Aim for a balanced valuation cap that protects both you and your investors.
• Consider offering a moderate discount rate (e.g., 20%) to incentivize early investors.

Plan for Future Rounds

Think ahead to how the convertible note terms will impact future funding. Avoid setting terms that could deter future investors.

Work with an Experienced Lawyer

Convertible notes may be simpler than equity deals, but they’re still legal agreements. Engage a lawyer with experience in startup financing to ensure you’re protected.

Alternatives to Convertible Notes

SAFE (Simple Agreement for Future Equity)

SAFEs are similar to convertible notes but don’t accrue interest or have a maturity date. They’ve become increasingly popular due to their simplicity and founder-friendliness.

Traditional Equity Financing

In some cases, raising equity directly may be a better fit, especially if you already have the traction to justify a strong valuation.

Revenue-Based Financing

For startups with steady revenue, this option allows you to repay investors from a percentage of your monthly income instead of giving up equity.

Real-Life Example: Convertible Notes in Action

Imagine you’re building a marketplace for sustainable products and want to raise $500,000 to develop your MVP and start marketing. You use a convertible note with:

• A 20% discount rate
• A $5 million valuation cap
• A 6% annual interest rate

When you raise a $3 million seed round at a $10 million valuation, your convertible note investors’ debt converts into equity at the $5 million cap, securing them a better deal than later investors.

Advanced Considerations for Using Convertible Notes

When to Avoid Convertible Notes

While convertible notes can be a great tool, they aren’t always the best choice. Here are scenarios where you might want to think twice:

1. If You’re Raising a Large Round: For rounds exceeding $2 million, equity financing might be more appropriate to ensure clear ownership stakes and avoid complex future negotiations.
2. When Your Business Is Hard to Value Even Later: Industries like deep tech or biotech, where value creation is slow and uncertain, may not benefit as much from convertible notes.
3. If You Lack a Clear Plan for Future Rounds: Convertible notes work well with a roadmap leading to a larger funding round. Without that, you could face issues at maturity.

Handling Convertible Note Complexity in Series A

When transitioning to a Series A round, you’ll need to account for all outstanding convertible notes. This includes interest accrued and any caps or discounts that apply. Engage a financial expert to ensure proper calculations and avoid diluting new investors or existing equity holders unfairly.

Convertible Notes vs. SAFEs: A Closer Look

Similarities

Both convertible notes and SAFEs delay valuation, provide investors with a future equity stake, and are designed for early-stage startups seeking simpler funding mechanisms.

Key Differences

1. Repayment Obligations: Convertible notes are debt instruments with a maturity date and interest, meaning there’s a repayment obligation if no equity conversion occurs. SAFEs have no repayment clause, making them less risky for founders.
2. Maturity Dates: SAFEs don’t expire, which can be beneficial if your next funding round is delayed. Convertible notes, on the other hand, often require renegotiation upon reaching their maturity date.
3. Investor Preferences: Some investors prefer convertible notes because they feel more secure with the debt structure. Others like SAFEs for their simplicity.

Which Should You Choose?

• Pick SAFEs if you want fewer legal complexities and don’t want to manage maturity dates or interest rates.
• Choose Convertible Notes if investors are concerned about downside protection and prefer the structure of debt.

Tips for Negotiating Convertible Notes

Know Your Market

Before entering discussions, research the standard terms for convertible notes in your industry and region. Terms like discount rates and valuation caps can vary widely depending on the startup ecosystem.

Build a Strong Narrative

Investors are betting on you and your vision. Clearly articulate your growth plan, market opportunity, and why you’re raising funds. Confidence and transparency can lead to more favorable terms.

Avoid Overly Aggressive Caps

While a low valuation cap might seem like a win for investors, it can deter others in future rounds. Strike a balance that rewards early backers without undermining your startup’s long-term growth.

Engage a Legal Expert Early

Negotiating convertible notes involves legal and financial nuances that aren’t always obvious. Partner with an experienced lawyer to ensure you’re not signing terms that could hurt your startup later.

Post-Convertible Note Best Practices

Keep Investors Engaged

Once you’ve closed a round using convertible notes, maintain regular communication with your investors. Share updates, milestones, and key challenges to build trust and keep them excited about your startup’s journey.

Prepare for Equity Conversion

When raising your next round, work closely with your financial and legal teams to ensure a smooth equity conversion process. Transparency and accuracy here can prevent disputes and delays.

Track Accrued Interest

Convertible note interest adds to the debt’s principal, impacting equity calculations. Use tools like cap table management software to keep accurate records and avoid surprises during conversion.

Leverage Notes for Strategic Growth

The funds from convertible notes can be used to hit critical milestones like product launches, customer acquisition, or proof-of-concept validations. Focus on delivering tangible results that can increase your valuation for the next round.

Convertible Notes in Global Contexts

Popularity in Different Ecosystems

Convertible notes are widely used in startup ecosystems like Silicon Valley, but their adoption varies globally. In emerging markets, traditional equity deals may still dominate due to unfamiliarity with alternative financing tools.

Regional Legal Considerations

Convertible notes are subject to local securities laws, which can differ significantly between countries. For instance:

• In the U.S., they must comply with SEC regulations.
• In Europe, investor protections and reporting requirements may vary by jurisdiction.

If you’re raising funds internationally, consult legal experts familiar with cross-border investments.

Exchange Rate Risks

For startups raising funds in foreign currencies, fluctuations in exchange rates can impact the value of your convertible notes. Hedge against these risks if you expect significant currency exposure.

Addressing Common Misconceptions About Convertible Notes

“Convertible Notes Are Only for Startups Without Revenue”

While they are often used by pre-revenue startups, convertible notes can also be effective for businesses with early traction. They’re particularly useful when you’re on the verge of a larger funding round and need bridge financing to scale or refine your product.

“Convertible Notes Are Always Risky for Founders”

The risk level depends on the terms you negotiate. Valuation caps, discount rates, and maturity dates can all be structured to balance investor rewards with founder protection. Working with a trusted advisor can help you strike this balance.

“Convertible Notes Are a One-Size-Fits-All Solution”

Every startup has unique funding needs. Convertible notes might be ideal for raising smaller, fast rounds, but they’re not the only option. For some startups, SAFEs, equity funding, or even non-dilutive financing could be better fits.

Convertible Notes for Non-Tech Startups

Convertible notes aren’t exclusive to tech startups. Businesses in sectors like food and beverage, retail, or even social enterprises can use them to raise funds. The same principles apply: investors exchange short-term debt for equity in the business, giving you flexibility to scale.

Example: Food Startup

Let’s say you’ve developed an innovative plant-based protein product and need $200,000 for manufacturing and marketing. Instead of setting an early valuation, you issue a convertible note with a $2 million valuation cap and a 10% discount. This gives you the funds to build traction and raise a larger equity round later.

Example: Social Enterprise

A nonprofit-style startup could use convertible notes to attract mission-driven investors, structuring terms that balance financial returns with the company’s social impact goals.

Tools to Simplify Convertible Note Management

Managing convertible notes can get complex, especially with multiple investors and rounds. Here are some tools that can help:

1. Carta: Tracks convertible notes, cap tables, and equity conversions seamlessly.
2. CapShare: Helps manage investor details, note terms, and equity scenarios.
3. Gust Equity Management: Offers tools tailored for startups, including convertible note tracking and automated cap table updates.
4. Simple Spreadsheets: For smaller teams, spreadsheets with well-structured formulas can be an affordable alternative for tracking notes.

Investing in proper tools ensures accuracy and makes scaling your fundraising efforts more efficient.

Frequently Asked Questions (FAQs) about Convertible Notes:

Q: Can convertible notes include performance milestones?

A: Yes, convertible notes can include clauses tied to specific performance milestones. For example, the valuation cap could increase if the company achieves certain revenue targets or user acquisition metrics before the note converts. This structure aligns incentives between founders and investors.

Q: Is there a minimum amount required to issue a convertible note?

A: There’s no strict minimum, but issuing convertible notes typically makes sense for rounds starting at $50,000 or more. Smaller amounts may not justify the associated legal costs, and alternative options like SAFEs or simple equity agreements might be more cost-effective.

Q: Can convertible notes be used in a pre-seed round?

A: Absolutely. Convertible notes are often used in pre-seed rounds where the company is too early to determine a valuation. They allow founders to raise funds quickly without the pressure of pricing their equity prematurely.

Q: What happens if no funding round occurs after the maturity date?

A: If no funding round happens by the maturity date, the note doesn’t automatically convert. The investor may request repayment, renegotiate the terms, or agree to extend the maturity date. This scenario highlights the importance of planning for future funding rounds when issuing convertible notes.

Q: Are convertible notes suitable for international investors?

A: Yes, convertible notes can be used for international investors, but it’s crucial to comply with local and cross-border legal requirements. You may also need to account for currency fluctuations and tax implications, making legal and financial advice essential.

Q: How do convertible notes affect employee stock option pools?

A: Convertible notes don’t immediately affect stock option pools since they don’t involve direct equity issuance. However, when the notes convert to equity, the added shares can dilute the pool, so it’s important to structure the option pool size with this future dilution in mind.

Q: Can convertible notes include non-financial benefits for investors?

A: Yes, some startups offer non-financial benefits alongside convertible notes to attract strategic investors. For example, an investor might gain early access to the product, exclusive partnership opportunities, or advisory roles.

Q: How does accrued interest impact the note’s conversion?

A: Accrued interest is added to the principal amount of the convertible note, increasing the total amount that converts into equity. For example, a $100,000 note with 6% annual interest over two years would convert $112,000 into equity.

Q: Is it possible to convert only part of a convertible note?

A: Partial conversion is rare but possible if agreed upon in the note’s terms. This can occur if an investor wants to split their investment between equity conversion and repayment, but it requires precise structuring and legal guidance.

Q: What role does a cap table play in managing convertible notes?

A: A cap table tracks ownership stakes, including how convertible notes will convert into equity during future funding rounds. Keeping your cap table updated ensures transparency and simplifies negotiations with new investors.

Q: How can founders mitigate dilution from convertible notes?

A: Founders can mitigate dilution by negotiating balanced valuation caps, raising sufficient capital in future rounds to absorb the conversion, and using dilution models to anticipate equity splits before agreeing to terms. Careful planning helps avoid unexpected equity losses.

Q: Are convertible notes publicly disclosed?

A: Convertible notes are private agreements and are not typically disclosed publicly. However, if the company is subject to financial audits or compliance reporting, the notes may appear in internal documentation or reports shared with investors.

Q: Can I use convertible notes to raise multiple rounds of funding?

A: Yes, startups often use convertible notes for multiple rounds, such as pre-seed and bridge financing. However, using them repeatedly without a clear equity round in sight can complicate cap tables and deter future investors. It’s important to plan your fundraising strategy carefully.

Q: Do convertible notes always convert during a funding round?

A: Not always. Convertible notes typically convert when a funding round meets specific terms, such as a minimum amount raised or a qualified round. However, they can also convert at maturity or upon specific trigger events, depending on the terms.

Q: Are convertible notes risky for investors?

A: Convertible notes carry some risk because they are dependent on the startup’s future success and the occurrence of a funding round. If the company fails or never raises additional capital, investors may not see a return or conversion. However, the valuation cap and discount rate help mitigate this risk by offering upside potential.

Q: Can convertible notes have different terms for different investors?

A: Yes, but it’s generally advisable to standardize terms for fairness and simplicity. Offering different terms, such as varying valuation caps or interest rates, can create friction among investors and complicate your fundraising process.

Q: How do convertible notes handle liquidation events?

A: In the event of a liquidation (e.g., acquisition or company closure) before conversion, the noteholders are typically treated as creditors. They are repaid their investment (and possibly accrued interest) before equity holders receive any proceeds, but this depends on the terms of the note.

Q: Can I issue convertible notes to friends and family?

A: Yes, but it’s crucial to ensure the terms are clear and legally sound. Friends and family often invest without a full understanding of the risks, so transparency about how convertible notes work and the potential outcomes is essential.

Q: What happens if an investor wants to exit before the note converts?

A: Convertible notes are typically illiquid, meaning they cannot be easily sold or transferred. If an investor wants to exit early, they would need to negotiate with the startup or find a third party to purchase the note, subject to any transfer restrictions in the agreement.

Q: How do I determine a fair valuation cap for my convertible note?

A: A fair valuation cap balances the risk for early investors with the potential dilution for founders. Research comparable startups in your industry and stage, and consider consulting with advisors or investors familiar with your market to set an appropriate cap.

Q: Are there alternatives to a fixed interest rate on convertible notes?

A: Yes, some convertible notes use a variable interest rate tied to a benchmark like LIBOR or SOFR. Others might forgo interest entirely in exchange for a higher discount rate or more favorable valuation cap.

Q: How do convertible notes interact with pro-rata rights?

A: Convertible notes themselves don’t typically grant pro-rata rights, but when they convert to equity, investors may negotiate these rights in the equity agreement. Pro-rata rights allow investors to maintain their ownership percentage in future funding rounds.

Q: Can I offer perks or rewards alongside a convertible note?

A: Yes, perks such as early access to products or exclusive updates can be offered to noteholders. While these are more common in rewards-based crowdfunding, they can help build goodwill with investors in smaller, community-focused funding rounds.

Q: Are there specific legal documents required for convertible notes?

A: Yes, the main document is a Convertible Note Purchase Agreement (CNPA), which outlines the terms of the note, including conversion triggers, interest rates, and valuation caps. Consulting with an experienced lawyer is essential to drafting this agreement.

Q: Can convertible notes include anti-dilution clauses?

A: While uncommon, some convertible notes may include anti-dilution provisions to protect investors from excessive dilution during conversion. However, these clauses can complicate future fundraising and are often avoided in early-stage rounds.

Q: How do convertible notes impact company valuation in the long term?

A: Convertible notes delay formal valuation until conversion, which can be beneficial in early stages. However, multiple notes with low caps or high discounts can significantly dilute founders and impact equity splits in later rounds, potentially affecting long-term valuation negotiations.

Need help with a convertible note? Contact Horizon Labs!

Convertible notes can serve as a versatile and founder-friendly financing tool, provided you approach them with a clear strategy and understanding of the terms. At Horizon-Labs.co, we’ve worked with startups at all stages, helping founders prepare for successful fundraising by building MVPs, scaling engineering teams, and creating impactful products.

If you’re considering using convertible notes to fund your growth or have questions about how to leverage them effectively, let’s chat. Contact us at info@horizon-labs.co or schedule a call at horizon-labs.co/contact. We’ll help you build your tech faster, smarter, and more cost-effectively—so you can focus on turning your vision into reality. Let’s get started!