Convertible Notes

What is a convertible note?#

A convertible note is a promissory note with an equity-conversion feature. The investor wires cash; in return the company owes the principal, interest under the stated rate and accrual convention, performance of the note's covenants, and repayment or another settlement if the note does not convert first.

The note also defines events that replace the debt claim with stock. The most common is a qualified financing: a later preferred-stock round raising at least a specified amount of new money. On that closing, the outstanding conversion amount typically converts automatically at a price more favorable than the one new investors pay. That favorable price comes from one or both of a discount (say, 20% below the new investors' per-share price) and a valuation cap (a ceiling on the valuation input used to compute the note's conversion price).

A note is not stock when issued. Before conversion the holder is a creditor, not a stockholder. Voting, board, information, and pro rata rights exist only if the documents grant them. In a weak outcome this matters: debt generally ranks ahead of equity, so repayment obligations can consume proceeds before common stock receives anything.

A note is still a security. Calling the instrument a loan does not remove securities-law obligations. Every offer and sale must be registered or qualify for an exemption. Many U.S. startups rely on Regulation D, where Form D is generally due within 15 days after the first sale and becomes public on EDGAR.

Why does this instrument exist?#

Convertible notes seem to be unfriendly to startup founders. Why Why does it exist, and why would a founder accept it?

It was not designed for seed rounds. Investors built them for bridge financings — short loans to companies already inside a portfolio, carrying them to a priced round that was already in view. Startups later borrowed the structure for first money because the paperwork was lighter than a priced round. The SAFE then took that borrowed use away, which is why notes fell to 7% of U.S. pre-seed rounds by Q1 2026.

What collapsed is the borrowed use, not the instrument. The original use is intact, and it explains every place notes still appear:

Accelerators are the exception that proves the point. It would be convenient to list them as a fourth row, but the leading published terms don't support it. Techstars offers its $100,000 note — $3,000,000 cap (adjustable to $5,000,000), 2-year term, 5% simple interest, 20% discount — as an optional add-on to a separate $20,000-for-6%-common arrangement, and states plainly that "companies may choose not to take the convertible note." A founder who doesn't want the debt can decline it and stay in the program. Where a note is a take-it-or-leave-it condition, that is a fact about your specific counterparty, not about accelerators as a class — so read the term sheet rather than assuming.

If you also take grant or other public money, check the interaction early; convertible loans can complicate some public funding programs in ways equity does not.

The deeper reason is that the note's cost is back-loaded and state-contingent. A SAFE's cost is dilution, which arrives at the priced round in the good state of the world. A note's distinctive costs — maturity pressure, a repricing negotiation, creditor priority — arrive only in the bad state, eighteen to twenty-four months out, when the round is late and cash is short. Founders are systematically bad at pricing costs shaped like that.

How does a note compare to a SAFE and a priced round?#

A note is not automatically "founder-friendlier" than a SAFE, and a SAFE is not automatically cheaper. Compare the whole package: amount raised, cap, discount, interest, time to conversion, priority, maturity remedy, exit treatment, side rights, and the expected next round.

Why notes connect runway to the next financing event#

A note is usually justified as a bridge to a milestone — a product launch, regulatory clearance, a revenue level, a margin improvement — that makes a priced round more attractive.

Required note raise = cash needed to reach milestone + execution buffer - cash on hand

Then test whether the milestone is likely well before maturity. A 24-month note funding 12 months of runway is not automatically safe; fundraising takes months, and a missed milestone leaves the company negotiating an extension while cash is scarce.

Interest increases dilution even when no cash is paid. Startup notes often accrue rather than pay interest. If accrued interest converts, it buys shares at the same favorable price.

Accrued interest = principal x annual rate x time outstanding

The note may use 365 days, 360 days, actual/actual, or compounding. Do not assume — a small per-note difference becomes material across a large stack or a delayed round.

What terms should you read before signing?#

Interest also raises tax questions. The IRS publishes Applicable Federal Rates monthly; below-market loans and original issue discount can create imputed-interest consequences. Do not pick a zero or unusually low rate without tax advice.

How does conversion actually work, step by step?#

1. Converting amount. principal + convertible accrued interest. Adjust if interest is cash-paid or waived.
2. Priced-round share price. pre-money valuation / priced-round capitalization. The negotiated option-pool increase changes this denominator and therefore the price.
3. Conversion price. Compute the discount price (round price x (1 - discount)) and the cap price (cap / company capitalization), then take the lowest price the note actually allows. The round's capitalization and the note's capitalization may not be the same number.
4. Shares. converting amount / conversion price, run separately for every tranche. Never average caps or discounts across notes.

Worked example: a $500,000 note converting in a seed round#

The $45,000 of interest alone buys 33,750 shares — 8.3% of the note's conversion shares. That is not a rounding error.

The priced round dilutes the noteholder too: immediately before the new money the note owns 6.38%, and after it owns 5.17%.

The trap the ownership table hides: liquidation preference#

The table above tracks ownership. It says nothing about priority, and priority is where the note gets expensive.

If the note converts into the same Series Seed preferred as the new investors — the most common default — it receives that series' liquidation preference per share, which is set by the price the new investors paid, not the price the noteholder paid.

The noteholder wired $500,000 and now sits ahead of common for $817,500 — an effective 1.64x liquidation preference, in a financing where nobody negotiated a preference multiple and the term sheet says "1x."

The general rule is worth memorising, because it needs no spreadsheet:

Effective preference multiple = priced-round share price / your conversion price

Here that is $2.0000 / $1.3333 = 1.50x on the converting amount, rising to 1.64x measured against cash actually wired because accrued interest converts too. The bigger the gap between your cap and the round's valuation — the outcome you were hoping for — the worse this gets. A note that converts at a quarter of the round price carries a 4x preference. Success creates the problem.

$317,500 of that preference stack is money nobody put into the company. It sits ahead of every share of common stock, including yours.

The usual fix is a shadow series: a parallel class, identical in rights, whose liquidation preference and dividend rate are set to the price the converting holder actually paid. It is well established and common in Series A charters, but not universal, and it is not free — it reduces the converting holder's preference, so expect some investors to push back rather than treat it as boilerplate. Raise it while the financing documents are being drafted. Retrofitting is possible with the consent of the affected holders and a charter amendment; it is simply a harder conversation once the preference already exists.

When does the cap control, and when does the discount?#

With 6,000,000 denominator shares and an $8,000,000 cap, the cap price is fixed at $1.3333. With a 20% discount, the two prices are equal when round price x 80% = $1.3333 — a round price of $1.6667, or a $10,000,000 pre-money valuation under the same denominator.

• Above a $10M priced-round valuation: the cap gives the lower price.
• Below $10M: the discount gives the lower price.

The cap is not always the controlling benefit, and a higher next round gives the noteholder more advantage relative to new investors.

What actually happens to a note? Every outcome, best to worst#

A note has one intended ending and six other ones. The document decides which, so read these against your signed terms rather than against what everyone says usually happens.

Cash repayment is real in three of seven states — and the ordinary "maturity arrived" case is not one of them. The dangerous states are an acquisition (5), a holder who has written you off and wants a recovery or a tax loss (6), and insolvency (7). A page that tells you "notes almost always convert" is describing state 1 and ignoring the tail.

State 4 is a common negotiated outcome, and it is where the note's real price gets set. The economics of a note are not fixed at signing so much as at the extension, which you may enter with weeks of runway and no alternative bidder. Some investors pre-commit: Techstars publishes that "if a Qualified Financing has not occurred prior to the Maturity Date, our practice is to extend the Note for another 1-year term." Most notes carry no such promise, and a headline cap on a note you may not convert before maturity is closer to a first offer than a price.

State 5 is where a good outcome turns bad. A modest acquisition — the kind that is a fine result for a small team — can fail economically if the note must be repaid before common stock sees anything. The Techstars form again shows the standard shape: on an acquisition before conversion the company pays "the greater of (i) a cash repayment equal to the unpaid principal and accrued interest, or (ii) the amount [the holder] would have been entitled to receive... if the... Note had been converted." Model your own clause against a realistic small exit, not against the exit in your deck.

On state 7, be precise about the law. A widely repeated claim holds that directors' fiduciary duties "shift to creditors" at insolvency. In Delaware that is not the rule. Directors continue to owe their duties to the corporation itself; what insolvency changes is standing — creditors may then bring derivative claims on the corporation's behalf, which they cannot do while the company is solvent (North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007); see also Quadrant Structured Products Co. v. Vertin). The practical caution survives the correction — near insolvency, decisions about repaying a noteholder versus funding operations stop being ordinary cap-table optimization and acquire litigation risk — but get jurisdiction-specific advice rather than relying on the slogan.

On frequency: practitioners agree cash repayment is uncommon and extension is the norm, but no public dataset measures how often notes are actually repaid, extended, or defaulted. Treat "notes almost always convert" as received wisdom rather than a measured fact, and price the tail yourself.

Pros, cons, and what to watch#

Traps, ranked by what they cost:

1. Liquidation overhang. Converting into the new investors' series at their preference per share creates a preference multiple you never negotiated — 1.64x in the example above, worse the better your round prices. Raise a shadow series while the charter is being drafted.
2. The definition of "company capitalization." This single defined term sets the cap price and can silently include or exclude the option pool, the pool increase, warrants, promised grants, and other notes and SAFEs. Two notes with identical $8,000,000 caps and different capitalization definitions convert at different prices. It is the least-read and most expensive term in the document.
3. The extension reprice. The note's real economics are set at maturity, not at signing (state 4 above). Negotiate the maturity remedy now — a founder-side extension right, or automatic conversion at the cap — while you still have leverage.
4. The change-of-control clause. Test it against a small, realistic acquisition. A repayment multiple can consume a modest exit before common stock receives anything.
5. Subordination and future debt capacity. A note is debt on your balance sheet until it converts. Venture and equipment lenders routinely require existing convertible notes to be subordinated and cap new ones inside a "permitted indebtedness" basket. A $500,000 insider bridge taken casually can price — or foreclose — the asset-backed facility that was your cheapest capital. A SAFE creates none of this. If your business will ever borrow against hardware, contracts, or receivables — as in hardware-as-a-service models — this belongs in the decision, and it is absent from most SAFE-versus-note comparisons.
6. The qualified-financing threshold. Set too low, a small insider round force-converts your notes; set too high, notes ride through a legitimate round as overhang.
7. Averaging tranches. Demonstrated above: a 12% error in the worked example, and the direction is not predictable — averaging can overstate or understate depending on tranche sizes and on which mechanism binds for each note.
8. Calling the cap a valuation. An $8,000,000 cap is a ceiling in a formula, not a statement of worth — but it will anchor your next negotiation as if it were one.

Sources#

1. U.S. Securities and Exchange Commission. Small Business Glossary. Regulatory definition of a convertible note as a loan, security, and future conversion instrument.
2. U.S. Securities and Exchange Commission. Private Companies and the SEC, Exempt Offerings, What Is Form D?, General Solicitation, and Early-Stage Investors.
3. Cooley GO. Primer on Convertible Debt, Frequently Asked Questions: Convertible Debt, and Series Seed Convertible Note Financing Package.
4. Clerky. Handbook: Fundraising — Convertible Notes. Origin of the instrument as a bridge financing tool.
5. Techstars. Investment Terms. First-party accelerator note terms, including the note's optional status, published extension practice at maturity, and greater-of change-of-control treatment.
6. Y Combinator. Announcing the Safe, a Replacement for Convertible Notes.
7. Carta. State of Pre-Seed: Q1 2026. Instrument mix across pre-seed rounds and dollars.
8. CRV. Convertible Notes for Startups: When and Why Investors Use Them (2026). Current market position, bridge role, and investor motivations.
9. Fenwick & West. Liquidation Preference Overhang and Shadow Preferred Stock, De-Mystified. Also Morse Law, Shadow Preferred Stock; Partridge Snow & Hahn, Beware the Liquidation Overhang; Veritas Global Law, Understanding the Shadow Series Provision.
10. North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007), and Quadrant Structured Products Co. v. Vertin, 115 A.3d 535 (Del. Ch. 2015). Creditor standing to bring derivative claims on insolvency; directors' duties continue to run to the corporation.
11. DLA Piper. Structuring for Convertible Notes in Venture Lending Transactions (May 2024). Subordination and permitted-indebtedness treatment of convertible notes in credit facilities.
12. Allied Venture Partners. What Happens When Convertible Notes Mature. Extension practice at maturity.
13. Kruze Consulting. Convertible Notes on the Balance Sheet. Liability classification prior to conversion.
14. Internal Revenue Service. Applicable Federal Rates, Publication 550, and Publication 1212.
15. Financial Accounting Standards Board. Accounting Standards Update 2020-06.

Educational note: This page explains financing mechanics for founders. It is not legal, tax, accounting, or investment advice. There is no universal convertible note — the executed documents, jurisdiction, securities exemption, and tax treatment control. Use qualified advisers for an actual transaction.