What Is a Convertible Note?
A convertible note is debt issued by an early-stage company that is designed to convert into shares rather than be repaid in cash. Instead of negotiating a full valuation at the seed stage, the company and investor agree on conversion terms and defer pricing until a later priced equity round, when professional investors set the value. This makes notes faster and cheaper to close than a full preferred stock financing.
Because it starts life as debt, a convertible note carries an interest rate, commonly 2% to 8%, and a maturity date, often 18 to 24 months out. In practice, almost nobody expects repayment. If the startup succeeds, the note converts into equity at the next financing; if the company fails, noteholders technically rank ahead of shareholders but usually recover little.
How Convertible Notes Convert
The two key economic terms are the valuation cap and the discount. The cap sets a maximum valuation at which the note converts, while the discount, typically 15% to 25%, lets the investor convert at a reduced price relative to the new round. When a qualified financing occurs, the note converts at whichever term produces the lower price per share, giving the early investor more shares for the same dollars.
Suppose an investor puts $500,000 into a note with an $8 million cap and a 20% discount, and the company later raises a Series A at a $16 million pre-money valuation. The cap price is half the round price, which beats the 20% discount, so the note converts at the $8 million cap. The investor effectively receives twice as many shares as a new Series A investor paying full price.
Why Convertible Notes Matter
Notes dominate seed-stage and bridge financings because they postpone the hardest negotiation, the company's valuation, and can be documented in days for minimal legal cost. Founders also use them between priced rounds as bridge capital when they need runway before a larger raise. Alongside SAFEs, they are the standard tool angels and seed funds use to get money into companies quickly.
For candidates recruiting into venture capital or growth equity, note mechanics show up constantly in cap table modeling. Interviewers may ask you to compute the conversion price under a cap versus a discount, or to explain how accrued interest adds to the principal that converts. Understanding where noteholders sit relative to equity holders is also a common test of capital structure intuition.
