What Is a Convertible Note and How Does It Work?

A convertible note is a financing tool structured as a debt instrument that can transform into equity under predetermined conditions. It functions as a loan from an investor to a company, which, instead of being repaid in cash, converts into ownership shares at a later date. Convertible notes are frequently used in early-stage company financing, especially in the startup ecosystem. They allow companies to raise capital without immediately setting a definitive valuation, which can be challenging for nascent businesses. This structure provides flexibility for both the company and the investor, bridging the gap between initial funding needs and future equity rounds.

Core Components of a Convertible Note

A convertible note agreement includes several fundamental elements that define its structure and eventual conversion. The principal amount is the initial sum of money an investor loans to the company.

An interest rate is applied to the principal, accruing over the note’s life. This interest is typically not paid in cash but accrues and is added to the principal, converting into equity alongside the original investment. This allows the company to preserve cash, useful for early-stage businesses.

The maturity date specifies when the note must convert or be repaid. This date often ranges from one to two years. If conversion conditions are not met, the note becomes due and payable.

A discount rate offers a percentage reduction on the share price at which the note converts during a future financing round. For example, a 20% discount on a $1.00 share price means conversion at $0.80 per share. This rewards early investors for their increased risk, ensuring they receive more shares than new investors in a later qualified financing round.

The valuation cap establishes a maximum company valuation for conversion, regardless of a higher valuation in a subsequent round. For instance, a $5 million cap means the note converts as if the company were valued at $5 million, even if the actual valuation is $10 million. This protects early investors from excessive dilution if the company’s value rapidly increases, ensuring a greater ownership stake.

Conversion triggers are specific events that cause the note to convert into equity. The most common trigger is a “qualified financing round,” a future equity funding round meeting a predefined minimum amount. Other triggers include company acquisition or the note reaching its maturity date without a qualified financing event. These triggers ensure conversion occurs under agreed-upon circumstances.

The Conversion Process

The transformation of a convertible note from debt to equity is a defined process, primarily dictated by the terms established in the note agreement. The most common scenario for conversion occurs during a qualified financing round, which involves the company raising equity capital from new investors. In this event, the principal and accrued interest of the convertible note convert into equity shares. The conversion price is determined by applying either the discount rate or the valuation cap, whichever results in a lower effective price per share for the noteholder.

To illustrate, consider a convertible note with a 20% discount and a $5 million valuation cap. If the company secures a qualified financing round at a $10 million valuation, and the new investors pay $1.00 per share, two calculations occur. First, applying the 20% discount to the new share price yields an effective conversion price of $0.80 per share ($1.00 (1 – 0.20)). Second, the valuation cap sets a maximum pre-money valuation for conversion; if the cap is $5 million, the note converts as if the company were valued at $5 million. The investor then receives shares based on the lower of these two prices, ensuring they benefit from either the discount for early investment or the protection of the cap if the company’s valuation significantly increases.

If the company does not complete a qualified financing round by the maturity date, the note typically becomes repayable. In such cases, the company might be obligated to repay the principal amount plus any accrued interest to the investor. Alternatively, the parties may agree to extend the maturity date, allowing more time for a qualified financing event to occur. In some agreements, the note might convert into equity at a pre-determined, often lower, “default” valuation if a qualified round does not materialize. This “default” conversion provides an alternative path to equity for the investor, albeit under less favorable terms for the company.

A change of control or acquisition of the company before a qualified financing round can also trigger conversion. In such events, the convertible note may convert into equity immediately before the acquisition, allowing the noteholders to participate in the sale proceeds as equity holders. Alternatively, the note might be repaid at a multiple of the principal amount, providing the investor with a return on their investment.

Common Scenarios for Convertible Notes

Convertible notes serve distinct purposes in the financing landscape, favored by both companies and investors for their flexibility and efficiency.

A primary use case is for early-stage startup funding. Nascent companies often lack a clear valuation, making traditional equity financing complex. Convertible notes allow these companies to raise capital quickly, deferring valuation discussions until a later, more established financing round. This streamlines fundraising, enabling startups to focus on product development and market traction.

Convertible notes are also utilized for bridge financing between larger equity rounds. Companies use these notes to secure interim funding to extend their runway, achieve milestones, or cover operational expenses until ready for a more substantial equity raise. This allows the company to continue its growth without undertaking a full, time-consuming equity valuation process prematurely.

The structure of convertible notes also appeals to angel and seed investors. These early investors often provide smaller check sizes and prefer a less complex investment vehicle than a full equity round. Convertible notes offer a simpler legal framework, reducing legal costs and complexity. The built-in incentives, like the discount rate and valuation cap, make the investment attractive despite the inherent risks of early-stage companies.