Glossary
What Is a Convertible Note?
Updated · Team Fonda
Short answer
A convertible note is a short-term loan to a startup that is designed to turn into shares at a later funding round instead of being repaid in cash. It carries interest and a maturity date, and usually a valuation cap, a discount or both.
Key takeaways
- A convertible note is debt first and equity later.
- Four terms do most of the work: interest rate, maturity date, valuation cap and discount.
- Interest is normally added to the amount that converts, so the investor ends up with more shares, not cash.
- Know what happens at maturity before you sign, because the loan can come due.
What a convertible note means in plain words
An investor lends your company money. Both sides expect that the loan will never be paid back in cash. When you later raise a priced round, meaning a round where investors buy shares at a set price, the loan plus its interest is swapped for shares. The note investor gets a better price than the new investors as a reward for coming in earlier.
Like a SAFE, a note lets you raise money without agreeing a valuation today. Unlike a SAFE, it is legally a debt until it converts.
The terms that decide how a note converts
| Term | What it means | Why you care |
|---|---|---|
| Principal | The amount lent | The starting point for conversion |
| Interest rate | Yearly interest that builds up on the principal | Adds to the amount that converts into shares |
| Maturity date | The date the loan is due if it has not converted | The investor may be able to ask for repayment |
| Valuation cap | The highest valuation used to price the conversion | A lower cap gives the investor more shares |
| Discount | A percentage off the next round's share price | Rewards the investor when there is no cap or the cap does not apply |
| Qualified financing | The size of round that triggers automatic conversion | A small round may not convert the note |
Formula
Shares on conversion = (principal + accrued interest) / conversion price. The conversion price is usually the lower of the discounted round price and the price implied by the valuation cap.
A worked example
All figures here are invented for illustration. Say an investor lends you $100,000 on a note with 6% simple interest a year, a 20% discount and a $4,000,000 valuation cap. Eighteen months later you raise a priced round at an $8,000,000 pre-money valuation and $1.00 a share.
- Accrued interest: $100,000 x 6% x 1.5 years = $9,000. Amount converting: $109,000.
- Discount price: $1.00 less 20% = $0.80 a share.
- Cap price: the cap is half the round valuation, so $1.00 x ($4,000,000 / $8,000,000) = $0.50 a share.
- The investor converts at the lower price, $0.50, and receives $109,000 / $0.50 = 218,000 shares.
- A new investor putting in $109,000 at $1.00 would receive 109,000 shares, half as many.
Those extra shares come out of everyone else's percentage. To see the effect on your own stake, run the round through the equity dilution calculator.
Convertible note vs SAFE
| Convertible note | SAFE | |
|---|---|---|
| Legal nature | Debt | Not debt |
| Interest | Yes | No |
| Maturity date | Yes | No |
| Converts at a priced round | Yes | Yes |
| Cap and discount | Common | Common |
General description. The documents you sign set the real terms.
Why it matters for a first-time founder
You may be offered a note at your first raise, often by an angel investor, or later as a bridge, which is a small raise to extend your runway until the next full round. Some investors prefer notes because being a lender gives them more protection than a SAFE if things go badly.
For you, the maturity date is the part that needs a plan. Work out how many months of cash the note buys with the startup runway calculator, and check that you can realistically reach a priced round before the note comes due.
Common mistakes
- Forgetting it is a loan. If the note matures without converting, the investor may have the right to demand repayment. Ask what your note says and what extension is possible.
- Leaving interest out of your model. The longer the note runs, the more shares it converts into.
- Stacking notes with different terms. Several caps and discounts make your cap table hard to read and your next round harder to negotiate.
- Skipping legal advice. Lending and securities rules differ by country and state. Have a startup lawyer review the note before you sign.
Frequently asked questions
Do you pay back a convertible note?
The intention is that it converts into shares, so no cash is repaid. It is still a loan, though. If it reaches its maturity date without converting, repayment, an extension or a conversion on agreed terms are the usual outcomes, depending on the document.
What happens if the company is sold before the note converts?
The note's own terms decide. Many notes give the investor a choice between being repaid, sometimes with a premium, or converting into shares just before the sale. Read that clause with your lawyer.
Is a convertible note better than a SAFE?
Neither is better in general. A SAFE is simpler for the founder because it has no interest or maturity date. A note gives the investor more protection. Which one you use often depends on what your investors are used to in your country.
Does a convertible note show up as debt on the balance sheet?
Generally yes, until it converts, because it is a loan. How it is recorded depends on the accounting rules where your company is based, so ask your accountant.