A convertible note is a debt instrument commonly used in early-stage startup financing that automatically converts into equity—typically preferred stock—when the company raises a subsequent round of funding. Unlike traditional loans that require repayment with interest, a convertible note allows investors to defer the equity valuation discussion until the company has more traction, converting their loan into shares at a discount to the next round's price or at a valuation cap, whichever is more favorable.
The typical structure includes an interest rate (usually 2-8% annually), a maturity date (commonly 18-24 months), a conversion discount (often 15-25%), and sometimes a valuation cap. When the startup raises its next priced equity round, the note converts automatically. For example, with a 20% discount, if new investors pay $1.00 per share, convertible note holders convert at $0.80 per share, receiving more equity for their initial investment.
Why It Matters
Convertible notes solve a critical problem in seed-stage investing: determining a fair valuation when a company has minimal revenue or traction is difficult and contentious. By postponing the valuation conversation until a Series A round when meaningful metrics exist, both founders and investors avoid dilution disputes and close deals faster—often in days rather than weeks. This speed and simplicity make convertible notes particularly attractive for angel investors participating in fast-moving seed rounds where delaying by even a few weeks might mean missing the opportunity entirely.
Example
Sarah invests $50,000 in a startup through a convertible note with a 20% discount and a $5 million valuation cap. Eighteen months later, the company raises a Series A at a $10 million valuation with shares priced at $2.00 each. Without the cap, Sarah's 20% discount would give her shares at $1.60. However, the $5 million cap means her investment converts as if the company were valued at $5 million, giving her shares at an effective price of $1.00 each. Sarah receives 50,000 shares instead of the 31,250 shares she would have gotten with only the discount, nearly doubling her equity stake.