Funding is essential in the early stages of starting a business, but valuation can be difficult to determine. When you don’t yet have any traction or revenue, how much is your idea really worth? Convertible notes are useful in this situation. Before a startup’s worth is established, these flexible investment tools are commonly used in startup fundraising. Convertible notes let investors finance your business now in return for startup equity later, typically at a discount or with other advantageous terms, rather than establishing a valuation up front.
What Is a Convertible Note?
A convertible note is a short-term loan given to a startup by an investor. But unlike traditional debt, the loan isn’t paid back with interest over time. Instead, it “converts” into equity when the startup raises a later round of financing, typically its first priced round.
In simple terms, investors give you money today, and in return, they get shares in your company down the line.
This structure is especially helpful during the seed investment stage, when assigning a company valuation might be too early or risky. Rather than spend weeks negotiating terms, founders and investors can use a convertible note to get funding quickly and move forward with building the business.
Why Convertible Notes Are Popular in Early-Stage Funding
Raising capital as a new founder can be intimidating, especially when you’re unsure how to value your business. That’s one reason convertible notes have become a go-to tool for early-stage funding.
One of the main appeals of a convertible note is its simplicity. When their business is only an idea or prototype, the founders don’t have to figure out how much it is worth. In contrast, investors value early entry and the possibility of greater returns when their investment is converted to equity.
Additionally, they produce a situation in which both parties benefit. Investors profit from taking a risk early, such as lower share prices or better valuation terms when the note converts, and founders receive funding without having to give up a significant amount of startup equity up front.
In many cases, convertible notes make the startup fundraising process faster, cheaper, and more flexible than traditional equity rounds.
Key Terms You Should Understand
Before diving into any convertible note agreement, it’s important to understand the key terms involved. These terms can have a significant impact on both your startup’s future and the investor’s returns.
Principal
This is the amount of money the investor loans to the startup. It will eventually be converted into equity based on the terms of the agreement.
Interest Rate
Although many startups don’t end up paying interest in cash, convertible notes often include an interest rate. The interest typically accrues over time and is added to the principal amount when the note converts.
Maturity Date
Every note has a maturity date—the point at which the loan comes due. If your startup hasn’t raised a qualifying funding round by then, the investor may request repayment or conversion under different terms.
Discount
To reward early investors for taking a risk, convertible notes often include a discount on the share price during the next round. For example, if new investors pay $1 per share, the note holder might pay only $0.80 per share if they have a 20% discount.
Valuation Cap
This is a ceiling on the company’s valuation when the note converts. It ensures that early investors get a better deal if your company grows rapidly and raises its next round at a high valuation.
Together, these terms shape the structure of your seed investment deal and influence how much startup equity is given away later.
How Convertible Notes Convert into Equity
The main event in a convertible note arrangement is the conversion. This happens when your startup raises a future equity round that meets certain conditions—often called a “qualified financing.”
When the note converts, the investor’s loan amount (plus any accrued interest) is exchanged for shares in your company. The price they pay per share will usually reflect the agreed discount or valuation cap.
Let’s take an example where your startup raises $2 million at a $10 million valuation in a Series A round. As if the company were worth only $8 million, shares would be awarded to an early investor who offered a $100,000 convertible note at a 20% discount. In other words, they receive more shares in return for their investment than the round’s new investors.
Convertible notes are very attractive for startup fundraising because of this conversion process. It allows founders to concentrate on growing their company rather than negotiating valuation right away, while also balancing investor risk and potential reward.
A Simple Example
Let’s say you’re launching a mobile app and secure a seed investment of $150,000 through a convertible note. The note includes a 6% annual interest rate, a 20% discount, and a $4 million valuation cap.
One year later, you raise a priced equity round at a $6 million valuation.
By then, the original investment has accrued some interest, say $159,000 total. With the valuation cap in place, the note converts as if the company is valued at $4 million instead of $6 million.
This means your early investor gets a larger portion of startup equity than they would have otherwise, rewarding them for their early support.
The Pros and Cons of Convertible Notes
Every funding tool has its advantages and drawbacks. Convertible notes are no exception.
One of their biggest advantages is speed. These agreements can be finalized relatively quickly, allowing startups to raise capital without a lengthy legal process. This is particularly helpful during the hectic phase of early-stage funding, when time is often a startup’s most valuable resource.
They also offer flexibility. Since there’s no need to set a valuation right away, startups can focus on product development and growth. Investors still get the upside when the company raises its next round and gains traction.
However, there are downsides. Because convertible notes are technically debt, they may come with pressure if no equity round is raised before the maturity date. In rare cases, investors may ask for repayment, which can be problematic for cash-strapped startups.
Additionally, if multiple convertible notes are issued with different terms, it can complicate the cap table and create confusion during future startup fundraising rounds. That’s why legal advice is crucial when structuring note agreements.
Alternatives to Convertible Notes
While convertible notes are widely used, they’re not the only tool available for seed investment. SAFEs (Simple Agreements for Future Equity), equity rounds, and even revenue-based financing are other popular options.
With the exception of the debt component, SAFEs are comparable to convertible notes. Their lack of a maturity date and interest accrual makes them more founder-friendly. Nonetheless, a note’s protections might be preferred by some investors.
However, if they are certain of their valuation or if investors are demanding clear ownership up front, some startups choose to go with a traditional equity round.
There are trade-offs with each option, and the best option will rely on your long-term startup equity distribution goals, investor expectations, and funding requirements.
What Founders Need to Keep in Mind
Using a convertible note may seem like an easy solution, but it still requires careful planning. You should always understand how these notes will impact your cap table, your control over the business, and your ability to raise money later.
If you offer deep discounts or low valuation caps, you might end up giving away more equity than you expect. That can affect not only your ownership but also how attractive your company is to future investors.
Timing also matters. If the maturity date arrives and you haven’t raised another round, you’ll need a plan. Most investors are supportive and won’t demand immediate repayment, but it’s better to have open communication and prepare for that scenario in advance.
Keeping clean records, standardizing terms across investors, and working with an experienced startup attorney will help you avoid surprises during your next startup fundraising phase.
From the Investor’s Perspective
Investors like convertible notes because they allow them to support early-stage startups without spending weeks negotiating ownership. They also get the potential upside of equity, especially if the startup succeeds and grows quickly.
For angel investors, convertible notes offer a straightforward way to invest in a promising idea with flexible terms. They take on more risk, but they also gain access to a future ownership stake that may be more valuable than the money they invested.
Founders who understand investor expectations—and communicate clearly about how and when the note will convert—build better relationships and raise capital more efficiently.
Tax and Legal Considerations
It’s easy to get caught up in the excitement of fundraising, but don’t overlook the legal and tax implications of convertible notes. Even though these are informal compared to equity rounds, they are still legally binding agreements that affect ownership, taxes, and control.
For example, investors might be required to report accrued interest as income even if they don’t receive it in cash. Founders should also think about how these conversions will affect future cap tables and valuations.
Engaging a startup-savvy attorney to help draft or review convertible note agreements is always a smart move—especially in early-stage funding where every decision has long-term implications.
Are Convertible Notes Right for Your Startup?
In the rapidly evolving world of startups, flexibility is crucial. That flexibility is provided by convertible notes, which allow you to raise seed money without having to worry about valuation while still paying early backers fairly.
They function best when applied strategically, which includes using clear terms, communicating openly, and keeping long-term startup equity planning in mind.
Knowing how convertible notes operate will help you make wiser financial decisions and forge closer bonds with the people who support your idea, whether you’re developing your MVP or getting ready to present it to angel investors.
