How a Convertible Note Works for Startups

A convertible note serves as a financial instrument used by early-stage companies to secure initial funding. It functions as debt that can transform into equity ownership at a later point. This mechanism allows startups to obtain capital without immediately assigning a definitive valuation to their business.

This financing acts as a bridge, connecting a company’s current funding needs with a future, more substantial equity investment round. Convertible notes offer flexibility for both investors and founders. This flexibility is beneficial in a startup’s early development, where traditional equity valuations are challenging to establish.

Key Elements of a Convertible Note

The structure of a convertible note incorporates several components. Each plays a specific role in how the investment functions and ultimately converts into equity. Understanding these elements is essential for both startups and investors.

The principal amount is the initial sum of money an investor loans to the startup. This base investment forms the core of the convertible note agreement. It represents the capital provided in exchange for future repayment or conversion into equity.

An interest rate is applied to the principal amount, similar to a traditional loan. Unlike standard debt where interest is paid periodically, interest on a convertible note accrues over time. This interest is added to the principal balance, and the combined amount is what eventually converts into equity, rather than being paid in cash to the investor. Common interest rates for convertible notes range between 5% and 10% annually.

A maturity date specifies when the convertible note, if not converted into equity, becomes due and payable. This date signifies when the startup must repay the principal and any accrued interest to the investor, or convert the debt into equity under pre-agreed terms. Notes commonly mature within 12 to 18 months, though some extend to 36 months.

A qualified financing event is a predetermined future equity funding round that triggers the automatic conversion of the convertible note into company shares. This event is defined by a minimum investment amount raised in that subsequent round or by the nature of the round itself, such as a Series A financing. The occurrence of such an event signals a significant milestone for the startup, indicating a more established valuation.

A valuation cap sets a maximum valuation at which the convertible note converts into equity, regardless of the company’s actual valuation in the qualified financing round. This protects early investors by ensuring they convert their investment at a more favorable, lower valuation than what later investors might pay if the company’s valuation significantly increases. It acts as a ceiling on the price per share, allowing early investors to capture more equity if the company performs exceptionally well.

A discount rate offers an incentive to early investors by allowing them to convert their investment into equity at a reduced price per share compared to what new investors pay in the qualified financing round. This percentage, ranging from 15% to 25%, is applied to the per-share price of the new equity round. The discount compensates early investors for the increased risk they undertake by investing in a company at a very early stage, prior to a formal valuation.

How Conversion Occurs

The primary objective of a convertible note is its eventual transformation into equity. This process unfolds under specific conditions. The most common scenario for conversion is a qualified financing event, a subsequent, larger equity funding round. During this event, the principal amount of the note, along with any accrued interest, converts into company shares.

When a qualified financing event takes place, the conversion price for the note is determined by comparing the valuation cap and the discount rate. The investor receives shares based on whichever mechanism yields a lower, more favorable per-share price. For instance, if a convertible note has a $10 million valuation cap and a 20% discount rate, and the new equity round values the company at $20 million, the investor benefits from the valuation cap. Their investment converts as if the company was valued at $10 million, allowing them to acquire shares at a lower price than new investors.

Conversely, if the new equity round values the company at $8 million, the discount rate would be more advantageous for the investor. With a 20% discount, the investor’s shares are priced at 80% of the $8 million valuation, meaning their investment converts at an effective $6.4 million valuation. This ensures early investors are rewarded for their initial risk, regardless of whether the company’s subsequent valuation is higher or lower than anticipated. Accrued interest also increases the total capital that converts, entitling the investor to more shares.

Should a qualified financing event not occur by the specified maturity date, the convertible note outlines alternative outcomes. One common option is for the startup to repay the principal amount of the note along with all accrued interest to the investor. This scenario functions like a traditional debt repayment, requiring the company to have sufficient cash reserves to fulfill this obligation.

Another possibility at maturity is for the note to convert into equity at a pre-determined valuation, which is a lower valuation specified in the note itself or a multiple of the principal amount. This conversion might occur into common stock or a specific class of preferred stock.

For founders, failing to secure a qualified financing round by the maturity date can lead to pressure to repay the debt or dilute their ownership at a less favorable valuation. For investors, this scenario means they might receive equity in a company that has not yet achieved the growth or valuation initially hoped for, or they might simply get their money back without the upside of an equity conversion.