What is a convertible note?
A convertible note is an early-stage fundraising mechanism that allows a startup to take in capital in return for debt that will eventually convert to equity. A convertible note is similar to a SAFE—in fact, it’s the instrument that SAFEs were designed to simplify and replace—but because it is a debt instrument, it has a few key differences.
Like a SAFE, a convertible note contains terms that explain how the investor’s stake will convert to equity when the startup raises a preferred stock round: typically these include a valuation cap and a discount. Because the convertible note delivers debt to the investors first, though, convertible notes also contain debt mechanisms: specifically, a maturity date that describes when the investment must be repaid and an interest rate.
A valuation cap refers to the maximum valuation allowed in this round—if the convertible note contains a valuation cap, any increase in the valuation above that cap will not affect the price of the equity that the convertible note’s investors receive. In other words, if a convertible note contains a valuation cap of $1M, but the startup closes its first round at a $2M valuation, the convertible note investors will receive an equity stake proportional to the $1M valuation instead.
The discount describes the amount by which the cost of the equity will decrease for the convertible note’s investors. If a convertible note specifies a 20% discount (which is typical), the money each investor puts in will translate to 125% of the shares their stake could buy at the price-per-share in the round—if a convertible note investor puts in $100 and the next round specifies a $1 price-per-share, their original stake would buy 125 shares at the discounted $0.80 price-per-share rather than 100.
Before a convertible note investment converts to equity, the startup treats it like a loan: the amount the investors put in accrues interest over time, and the note describes when the loan must be repaid. These mechanisms almost never result in the note being repaid as a loan, though—in most cases, the startup will either raise a subsequent equity round or fail before that. If the startup raises a round, the convertible note investors will receive equity for their stake; if the startup fails, the investors will generally write the debt off.
Instead, the debt mechanisms impact the investors’ stake. The interest rate technically increases the amount of debt the investors own, but that debt translates to equity at the next round, so the interest has the effect of increasing the investors’ equity stake over time, effectively rewarding investors for their patience and for making a riskier investment the longer the startup takes to prove itself.
Meanwhile, the maturity date is included because it is a necessary component of a loan. None of the parties signing a convertible note actually expect the loan to be repaid, but since it is a loan, the debt needs to have a deadline for payment.