Overview
A convertible note is a debt instrument that converts into equity at a future financing round. It's the dominant financing mechanism for pre-seed and seed stage companies because it solves the hardest problem in early-stage investing: valuation. When a company is pre-revenue or pre-product, agreeing on a price per share requires agreeing on a valuation — a number that may be arbitrary and contentious. A convertible note defers that conversation to the next priced round, when there's more information to base a valuation on.
The mechanics are straightforward. The company borrows money from investors. Instead of repaying the principal with interest, the note converts into preferred stock at the next qualified financing round. The conversion terms — how many shares the noteholder receives — are governed by two key economic parameters: the valuation cap (the maximum valuation at which the note converts, protecting early investors from excessive dilution if the company's value skyrockets) and the discount rate (a percentage reduction from the next round's price per share, rewarding early investors for their risk).
Despite its apparent simplicity, convertible note financing has generated significant complexity and litigation as companies accumulate multiple notes at different caps and discounts, miss maturity dates, and struggle with conversion mechanics in complex subsequent rounds. The "SAFE stack" problem — multiple SAFEs and convertible notes converting simultaneously in a Series A, creating unexpected dilution — has surprised many founders who didn't model the conversion math before raising.
Convertible notes are debt, not equity. This distinction matters in several important ways: notes appear on the company's balance sheet as liabilities (which can affect debt covenants in other agreements), note interest accrues and is either paid or added to principal, and if the note reaches its maturity date without a qualifying financing event, the investor has a right to demand repayment of principal plus interest — a right that can force an insolvent company into involuntary bankruptcy if not carefully managed.
Key Clauses to Review
Valuation Cap
The maximum company valuation at which the note converts to equity, regardless of the actual valuation of the next financing round. If a note has a $10M cap and the Series A is priced at a $30M pre-money valuation, the noteholder converts as if the valuation were $10M — receiving three times as many shares as Series A investors for the same dollar amount invested. The cap protects early investors from being diluted to insignificance if the company's value grows dramatically between the note and the priced round. Cap negotiation is the most economically significant conversation in convertible note financing.
No valuation cap at all — uncapped notes provide no protection against extreme dilution in a high-valuation Series A. Cap set so high it provides no meaningful protection relative to expected Series A valuation. Missing definition of whether the cap applies to pre-money or post-money valuation — this distinction significantly affects conversion share count. No most-favored-nation (MFN) clause if the company issues subsequent notes at lower caps — early investors should receive the benefit of better terms offered to later note investors.
Discount Rate
A percentage reduction from the next round's price per share applied when the note converts. A 20% discount means a noteholder converts at 80% of the Series A price per share — receiving 25% more shares than Series A investors for the same amount invested. The discount compensates early investors for the additional risk they took before the Series A validation. Standard discounts range from 10-25%; 20% is most common. Where both a cap and a discount apply, the noteholder typically receives whichever mechanism produces more shares (i.e., the better economic outcome for the investor).
No discount rate and no valuation cap — noteholders receive the same terms as Series A investors despite taking substantially more risk. Discount applied to the post-money valuation rather than share price — this produces a different (and typically worse for investors) result. Missing specification of which mechanism (cap or discount) applies when both are present — should always be "whichever produces more shares for the investor." Discounts exceeding 30% that create Series A investor resistance to closing (they're pricing in earlier investors at a steep discount).
Interest Rate and Accrual
Convertible notes bear interest — typically 4-8% per annum — which either accrues and converts to equity with the principal at the next round or is paid in cash. Most startup convertible notes use accruing interest that converts alongside principal, avoiding cash interest payments the company typically can't afford. The interest rate is often set at the minimum applicable federal rate (AFR) to avoid IRS imputed interest issues for related-party loans. Interest calculation method (simple vs. compound, day count convention) should be specified explicitly.
Interest rates significantly above market (above 8-10% for startup notes) that create substantial accrued interest burdens. No specification of whether interest is simple or compound — this matters for large notes or long periods. Missing specification of the interest accrual start date. Provisions allowing the investor to demand cash interest payment rather than conversion — defeats the purpose of a convertible note for cash-constrained startups. No clarity on how accrued interest is treated in a change of control that doesn't qualify as a conversion event.
Maturity Date and Default
The date by which the note must either convert or be repaid. Most seed convertible notes have 18-24 month maturities, reflecting the expected timeline to a Series A. If no qualifying financing occurs before maturity, the investor can demand repayment of principal plus accrued interest — a right that can force a company into insolvency if it lacks the cash. Well-drafted notes include: automatic conversion into a new series of preferred stock at a specified price if no qualified financing occurs, or the right for investors to convert at the cap price at maturity rather than demanding repayment.
Short maturity dates (under 18 months) that don't give the company adequate time to reach a Series A. No automatic conversion provision at maturity — leaving the company exposed to a demand for cash repayment. Maturity provisions that give individual investors the right to accelerate independently rather than requiring majority noteholder consent. Missing forbearance mechanics — what happens if the company requests an extension and investors don't respond. No specification of governing law for enforcement of maturity default claims.
Qualified Financing Definition
Defines the type and size of financing that triggers automatic conversion of the note. Typically: a preferred stock financing raising at least a specified minimum amount (e.g., $1M, $3M, $5M depending on company stage). The threshold is important — too low and notes convert prematurely in a small bridge; too high and notes may never convert if the company raises a series of smaller rounds. Should also address: what happens in a non-qualified financing (the investor may have the option but not obligation to convert), and how conversion mechanics work in a complex round with multiple closings.
Qualified financing threshold so low it triggers conversion in any bridge round. Missing definition of what constitutes "proceeds" for threshold calculation — gross vs. net of fees. No provision for partial conversion if a financing partially meets the threshold. Ambiguous treatment of SAFE conversions at the same round — do SAFEs count toward the qualified financing threshold? Missing mechanics for conversion in a round that closes in multiple tranches over time.
Change of Control and Acquisition Treatment
Specifies what happens to the note if the company is acquired before the note converts. Options: (1) the investor receives repayment of principal plus a multiple of the invested amount (e.g., 2x); (2) the note converts at the cap price and the investor participates in the acquisition proceeds as a preferred stockholder; or (3) the investor can elect between repayment and conversion. Change of control provisions significantly affect founder economics in an early exit — a 2x repayment to all noteholders on a $5M acquisition of a company that raised $3M in notes leaves very little for founders.
No change of control provision at all — note terms in an acquisition are entirely negotiated at the time of sale, with no contractual baseline. Automatic 2x or higher repayment multiples that effectively prevent any founder-favorable acquisition below a high threshold. No investor election right between repayment and conversion — forcing one outcome may be suboptimal for both parties. Missing definition of what constitutes a "change of control" — asset sales, mergers, and majority share sales may be treated differently.
Risk Assessment
The SAFE/convertible note stack problem is the most common and most surprising dilution event for founders. Companies that raise multiple rounds of convertible notes and SAFEs at different caps often fail to model the cumulative conversion dilution until the Series A term sheet arrives. In a worst-case scenario, a company that raised $2M in notes at a $5M cap and $3M in SAFEs at an $8M cap, then prices a Series A at a $20M pre-money, may find that the conversion of all prior instruments consumes 40-50% of the post-money capitalization — leaving the Series A investors with far less than anticipated and triggering a renegotiation or collapse of the round.
Maturity date risk is acute and underappreciated. Founders who raise convertible notes with 18-month maturities and then fail to close a Series A face a choice: negotiate extensions (possible but requires investor consent and often involves worse terms), convert at an unfavorable price, or face demands for repayment the company cannot fund. A demand for repayment on notes the company cannot repay is effectively a forced insolvency event. Every convertible note round should include a realistic assessment of whether the company can reach a qualifying financing within the maturity period.
Interest accrual compounding is a second-order dilution source that founders overlook. A $500K note at 6% interest accruing for 24 months generates $60K in accrued interest that converts to equity alongside principal. On a 1,000-note round, the accrued interest adds meaningful dilution on top of the principal conversion. This is not a large number individually but compounds across multiple note rounds.
Tax treatment of convertible notes has nuances that can create unexpected tax liabilities for both companies and investors. The original issue discount (OID) rules may require investors to recognize income on accruing interest before receipt. Section 1202 qualified small business stock (QSBS) treatment — which provides potentially enormous capital gains exclusions — depends on how and when the note converts to equity. Tax counsel should be consulted for notes above $1M.
Best Practices
Model the full conversion dilution before issuing any convertible note. Build a cap table model showing ownership percentages after conversion of all outstanding notes and SAFEs at their respective caps, alongside the new Series A investors. Do this before issuing the note, not after. The model should show founder and employee ownership at the Series A close under multiple scenarios: Series A at 1x cap, 2x cap, and 3x cap valuation. If the founder ownership after full dilution is uncomfortably low at realistic valuations, the note terms or amount need adjustment.
Standardize on a single note form per round. Issuing multiple notes with different caps, discounts, and terms to different investors in the same round creates conversion complexity and potential disputes about MFN provisions. If different investors receive different economics, document why explicitly and ensure MFN provisions are addressed.
Set the qualified financing threshold at a meaningful amount — typically the minimum size of a Series A in your market. For most US startups in 2024, $3-5M is a reasonable threshold. A threshold that's too low causes premature conversion; too high means notes persist through multiple small rounds without converting.
Always include an automatic conversion provision at maturity as an alternative to repayment. The most investor-friendly maturity provision converts the note into a new series of preferred stock at the cap price if no qualifying financing has occurred. This avoids the insolvency risk of cash repayment demands while giving investors equity they can value. Investors generally prefer conversion to repayment from an insolvent startup anyway — the provision aligns incentives.
Frequently Asked Questions
What's the difference between a convertible note and a SAFE?
Both convert to equity at a future financing round, but a convertible note is debt (with interest, maturity date, and repayment rights) while a SAFE is neither debt nor equity — it's a contract right to receive equity in the future. SAFEs have no maturity date, no interest, and no repayment obligation, making them simpler and more founder-friendly. Convertible notes create a balance sheet liability and a real obligation to repay if conversion doesn't occur. YC-standard SAFEs have largely replaced convertible notes for seed financing in the US venture ecosystem, though convertible notes remain common in other contexts.
What happens if the company is acquired before the note converts?
It depends on the note's change of control provision. Common outcomes: the investor receives a cash payment equal to a multiple (typically 1x-2x) of the principal; the note converts to equity at the cap price and the investor participates in the acquisition as a preferred stockholder; or the investor elects between the two options. Without a specific change of control provision, this is negotiated at the time of acquisition — which is the worst possible time to negotiate for founders. Always address change of control treatment explicitly in the note.
What is a most-favored-nation (MFN) clause in a convertible note?
An MFN clause gives the noteholder the right to receive the benefit of any more favorable terms offered to subsequent note investors in the same or a later bridge round. If you issue notes at a $5M cap and later issue notes to different investors at a $4M cap, MFN-protected noteholders can elect to convert at the $4M cap. MFN clauses protect early investors from being disadvantaged relative to later investors in the same financing stage. They're standard in SAFE documents and common in convertible notes.
What is a reasonable valuation cap for a seed convertible note?
It depends on the company's stage, traction, and market. Pre-product companies typically see caps of $3-8M; post-MVP companies with some traction $6-12M; companies with strong traction and revenue might command $10-20M+. The cap should reflect the company's current fair value with a modest discount for liquidity risk — it shouldn't be set so high it provides no economic protection to the investor, or so low it creates excessive dilution if the company grows faster than expected. Market rates shift over time; check current YC and AngelList data for current benchmarks.
Can I extend a convertible note past its maturity date?
Yes, with investor consent — which is usually obtainable if the company is making progress and the relationship is healthy. Extensions typically require a simple majority of noteholders by principal amount. The negotiating dynamics at extension are different from the original note: investors have leverage and may seek improved terms (lower cap, higher interest, or a warrant). The best strategy is proactive communication well before maturity — don't let investors discover the note is maturing without a plan. If you need an extension, approach investors 60-90 days before maturity with a clear plan for the path to conversion.