Convertible Notes: How Angels Evaluate the Terms

TL;DR: A convertible note is a loan that turns into equity at a startup's next priced round. Three terms decide what you end up with: the valuation cap, the discount and the maturity date. The cap and discount set your price per share. The maturity date decides what happens if no round ever comes.

If you already write checks into early-stage companies, you've seen the term sheet. Reading it as the person whose money is at risk is the harder job. What follows takes each term from the investor's chair, then covers the two ways a note goes wrong: you end up owning less than you expected, or you hold paper that never converts and never gets repaid.

What are you holding when you sign a convertible note?

You're holding debt that is meant to become equity. Eqvista describes it as a short-term debt instrument that converts into company equity at a future date, typically when the startup raises its next funding round.

Until that round happens, you don't own shares. Breaking Into Wall Street points out that when a startup raises seed capital on convertible notes, nothing changes in the cap table because the investors do not receive direct ownership. Your money is in the company, but your name isn't on the ownership list, which is why the terms below carry so much weight.

For the longer background on the instrument, AIN's earlier guide on how angel investors get equity without a priced round covers the mechanics. This piece is about evaluation.

How does the valuation cap set your price?

The cap sets the highest valuation at which your note converts, no matter how high the next round prices the company. AngelList gives the example: if the valuation cap is $5M and the priced round has a post-money valuation of $10M, the noteholders effectively invest as if they're coming in at the lower valuation of $5M.

The cap only helps when the round prices above it. If the company raises below the cap, the cap does nothing and you convert at the round price, less any discount. So the first question is where the company is likely to price its next round. A cap set far above that number protects you from very little.

How does the discount work, and which one wins?

The discount lowers your conversion price relative to what new investors pay. When a note carries both a cap and a discount, you generally convert at whichever gives the lower price. Eqvista works through an example: an investor puts in $40,000 with a 20% discount and a $3M cap, and the company later prices a Series A at a $6M valuation and $6 per share. The discount gives $4.80 per share. The cap gives $3 per share, so the investor takes the cap and receives approximately 13,333 shares.

Term	How the price is set	Example price per share
Discount only (20%)	20% off the new round's price	$4.80 on a $6.00 round
Cap only ($3M cap, $6M round)	Cap divided by round valuation, times round price	$3.00
Both	Whichever price is lower	$3.00

The figures above come from Eqvista's worked example. Read across the rows and the pattern is plain: the discount protects you in a modest round, and the cap protects you in a big one. A note with only a discount leaves you exposed if the company's value jumps, because a fixed percentage off a high price is still a high price. Eqvista's cap-only example shows the other side. With a $6M cap and a $12M Series A at $12 per share, the investor converts at $6 per share, and $60,000 buys 10,000 shares versus 5,000 without the cap.

What does the maturity date mean for you?

The maturity date is the day the loan side of the note comes due. In a model term sheet from the Penn Carey Law School startup kit, outstanding principal and unpaid accrued interest become due and payable upon request of the majority holders, made on or after the date 24 months from the initial closing.

Two details in that language matter to you. Repayment is triggered by the majority holders, so a small check doesn't give you the power to demand your money back on your own. And being owed money is not the same as being paid. A seed-stage company that has spent its cash can't hand it back on request. In practice, maturity tends to become a negotiation with the founder: extend the note, convert it at a set price, or restructure it. That last point is an inference about how these situations usually play out, not a figure from any source cited here.

How can a convertible note leave you diluted or unpaid?

A note can leave you holding paper that doesn't convert on the schedule you assumed, or that converts into less than you expected. The table lists the usual causes and what to look for in the term sheet.

What goes wrong	Why it happens	What to check in the term sheet
The note never converts	The round is smaller than the qualified-financing threshold	The minimum round size that triggers conversion
The cap does nothing	The next round prices below the cap	Cap versus realistic next-round valuation
The discount is thin	A small percentage off a high price still buys few shares	Discount size, and whether a cap sits beside it
Maturity arrives with no round	The company has no cash and no new investors	Maturity length, extension terms, who can call the note
You have no say before conversion	You are a creditor, not a shareholder	Information rights and side-letter terms

The first row deserves a closer look. AngelList notes that if the term sheet says conversion happens only if $2M or more is raised, and only $1M is raised, the note would not yet convert to equity. You can sit through a perfectly real financing and still be holding a note.

Dilution works differently. The note itself doesn't dilute you before conversion, because you own no shares yet. The risk shows up at conversion, when your shares are priced and the company's other terms, such as how much it sets aside for future employees, come into play. Those choices are made in the priced round and sit outside your control, so ask the founder how they plan to structure it.

And if the company simply fails? A note holder is a lender, which can sound safer than being a shareholder. How much a lender recovers depends on what the company has left and who else is owed money. Treat the principal as at risk of total loss, as with any early-stage check.

Common mistakes angels make with convertible notes

The most common mistake is reading the cap and ignoring everything around it. A generous cap paired with a high qualified-financing threshold can still leave you waiting. Another is counting on the interest rate to do the work. Interest accrues on a small base and typically converts into shares rather than arriving as cash, so it adds modestly to your position and is not a payout.

Skipping the conversation about maturity is a third. Founders rarely want to discuss the note coming due, but the time to agree on what happens is before you wire funds. The last is treating a note and a SAFE as interchangeable. A SAFE carries no maturity date and no interest, so the protections you're weighing here don't exist there. AIN's downside view of notes versus SAFEs and the SAFE vs. convertible note playbook lay out that trade-off in detail. For a broader checklist, see what angel investors must know before they sign.

FAQ

What is a convertible note and how does it work?

It's a short-term loan to a startup that converts into equity, usually when the company raises its next priced round. Your conversion price comes from the valuation cap, the discount, or both. Until then you hold debt, not shares.

What are the disadvantages of convertible notes?

You have no ownership or vote before conversion. The note may not convert if the next round falls below the stated threshold. A cap set above the next round's valuation gives you little protection, and a company short on cash may not be able to repay at maturity.

Do you have to pay back a convertible note?

Technically yes, because it's debt. In a Penn Carey Law model term sheet, principal and accrued interest are due on request of the majority holders after 24 months. Whether the company can pay then depends on its cash, so extensions and conversions are common negotiation outcomes.

What happens to a convertible note if the startup fails?

Your note is a claim on whatever the company has left, shared with its other creditors. Early-stage companies that fail usually have little left, so plan for the possibility of losing the full amount. Recovery depends on the company's remaining assets and its debts.

Your next step

Pull up the note you're considering and write down the cap, the discount, the qualified-financing threshold and the maturity date. Then work out how many shares your check buys if the next round prices at half the cap, at the cap, and at double the cap. If any answer surprises you, take it to the founder before you sign.

Educational content only. Not investment, tax, or legal advice. Not an offer or solicitation to buy or sell securities. Past performance does not guarantee future results. Private-market investments are illiquid and involve risk of loss, including total loss of capital. Consult qualified advisers. Angel Investors Network is not a broker-dealer or investment adviser.