Founding Attorney
A convertible note is a loan that turns into ownership. Startups use it to raise money quickly, without setting a company valuation on day one. The investor lends funds today and receives equity later, usually when the company closes its first priced financing round. The instrument looks simple. However, a handful of terms inside it decide how much of your company you are actually selling. This guide explains how a convertible note works, the terms that matter, and how to prepare one properly.
What Is a Convertible Note?
Legally, a convertible note is a debt instrument. It carries a principal amount, an interest rate, and a maturity date. Unlike an ordinary loan, though, neither side expects repayment in cash. Instead, the note converts into shares when a defined trigger occurs, most commonly a qualified equity financing. Consequently, the note lets both sides defer the hardest question in early-stage investing, which is what the company is worth.
How a Convertible Note Works
The lifecycle runs in three stages. First, the investor funds the note, and interest begins to accrue, typically as paid-in-kind interest that increases the conversion amount rather than cash. Second, the company grows and eventually raises a priced round from new investors. Third, the note converts automatically into the same class of shares issued in that round, at a price improved by the note’s discount or valuation cap. If no financing happens before maturity, the parties must deal with the note, for example by extending it, converting at an agreed valuation, or repaying it.
Key Terms in a Convertible Note
- Discount rate. Rewards early risk by letting the investor convert at a percentage below the new round’s price, commonly in the range of ten to twenty-five percent.
- Valuation cap. Sets a maximum company valuation for conversion. If the priced round values the company above the cap, the noteholder converts as if the valuation were the cap, receiving more shares.
- Interest rate and maturity. Interest usually accrues and converts. Maturity, often one to three years out, creates the deadline that forces a resolution.
- Qualified financing threshold. Defines how large a priced round must be to trigger automatic conversion.
- Change of control terms. Decide what happens if the company is acquired first, commonly repayment at a premium or conversion at the cap.
- Amendment provisions. Determine whether a majority of noteholders can bind the rest, which matters when notes are issued to many investors.
A Simple Convertible Note Example
Suppose an investor puts one hundred thousand dollars into a note with a twenty percent discount and a five million dollar cap. A year later, the company raises a priced round at one dollar per share on an eight million dollar valuation. The discount would give a conversion price of eighty cents. The cap, however, produces a better result for the investor, roughly sixty-two cents per share, because five million divided by eight million equals that fraction of the round price. The note converts at the lower of the two. As a result, the investor receives materially more shares than a new investor paying full price.
Convertible Note vs SAFE: Which Should You Use?
The SAFE, or simple agreement for future equity, was introduced by Y Combinator as a streamlined alternative. A SAFE is not debt. It has no interest rate and no maturity date, which removes the repayment pressure a note creates. Founders often prefer SAFEs for exactly that reason. Investors, by contrast, sometimes prefer a convertible note because maturity gives them leverage and because debt ranks ahead of equity if the company fails. Market practice also varies by geography and industry. Neither instrument is better in the abstract, so choose based on your investors’ expectations and your realistic financing timeline.
Securities Law Still Applies
A convertible note is a security under United States law. Every issuance must therefore be registered or exempt, and most startups rely on Regulation D. The antifraud rules apply regardless of exemption, so disclosures to investors must be accurate. In addition, state blue sky filings and accredited investor checks deserve attention at closing. These steps are inexpensive when done on time and costly to fix afterward. For the broader fundraising picture, see our equity investment legal guide.
How to Make a Convertible Note: Step by Step
- Confirm board and, where required, shareholder approval for the issuance.
- Agree the economic terms: amount, discount, cap, interest, maturity, and triggers.
- Draft the note purchase agreement and the note itself, keeping terms consistent across all investors in the round.
- Verify securities law compliance, including investor accreditation and any required filings.
- Close, collect funds, and record the notes in your capitalization table so future dilution is modeled correctly.
Common Mistakes to Avoid
Three errors appear again and again. Founders stack multiple notes with different caps and forget the combined dilution until the priced round arrives. They let notes pass maturity without documentation, leaving technically defaulted debt on the books. Similarly, they promise side terms to favored investors in emails, which surfaces during diligence years later. Discipline in drafting and record-keeping prevents all three.
Frequently Asked Questions
Does a convertible note need a valuation cap?
No, but most investors expect one. An uncapped note gives the investor no protection against a high-priced round. Uncapped notes still appear where founders have unusual leverage.
What happens at maturity if there is no financing?
The note becomes due. In practice, investors rarely demand repayment from a working startup. Instead, the parties typically extend the maturity date or negotiate a conversion at an agreed valuation. Nevertheless, the legal right to demand payment exists, which is why the deadline matters.
Can foreign investors purchase a convertible note?
Yes, and cross-border participation is common. However, foreign investment can add tax, reporting, and in some industries regulatory review considerations, so both sides should take advice before closing.
How Transnational Matters Can Help
We prepare convertible note financings for founders and investors, from term sheet through closing, including cross-border rounds. Our team drafts the documents, handles securities compliance, and negotiates terms that stand up when the priced round finally arrives. To get your raise structured correctly, learn how our business law lawyers work with growing companies, or contact our Miami office today.