Finance term
Convertible Note
Also known as: convertible debt, convertible promissory note
Definition
A convertible note is a short-term debt instrument used in early-stage startup financing that converts into equity at a future priced financing round. The investor lends money now; instead of repaying cash at maturity, the note converts to shares at a discount to the next round's price.
Detailed explanation
Convertible notes bridge the gap between a startup's current need for capital and a future priced equity round. Rather than negotiating a valuation today (which is difficult for very early companies), the investor and company agree to convert the loan into equity at the price set in the next qualifying financing round — typically at a discount (15-25% is common) to reward the early investor for taking more risk.
Key terms in a convertible note: (1) Principal — the investment amount. (2) Interest rate — accrues on the principal (typically 4-8%/year), usually converts alongside principal rather than being paid in cash. (3) Maturity date — typically 18-24 months; if no qualifying round occurs by maturity, the note either becomes payable (rarely exercised) or is extended. (4) Discount rate — conversion price = next round price × (1 - discount). A 20% discount means if the Series A prices at $2.00/share, the note converts at $1.60/share. (5) Valuation cap — maximum valuation at which the note will convert, regardless of the actual next-round valuation. Protects investors if the company's valuation spikes dramatically. (6) Qualifying financing — the minimum threshold (typically $500K-$2M raised) that triggers automatic conversion.
Convertible notes are commonly issued under SEC Regulation D 506(b) or 506(c) private placement exemptions (https://www.sec.gov/smallbusiness/exemptofferings/exemptofferings). They are not registered securities, but issuers must file Form D with the SEC within 15 days of first sale. Eligible investors include accredited investors; Rule 506(b) allows up to 35 non-accredited sophisticated investors.
Note: convertible notes are debt, creating a balance-sheet liability until conversion. SAFEs (below) are not debt. This matters for businesses with debt covenants or lenders who scrutinize leverage ratios.
◈ Worked example
- $250K convertible note, 20% discount, $5M cap, 6% interest, 24-month maturity. Series A prices at $10M valuation, $1.50/share → note converts at $1.20/share (20% discount) or at cap price — whichever is lower, benefiting the investor.
- Angel invests $100K convertible note with $3M cap. Company raises Series A at $8M valuation → investor converts at $3M cap valuation, not $8M — more shares than later investors at same dollar amount.
- Note matures without a qualifying round: investor can demand repayment or agree to extend. Most founders negotiate an extension rather than a cash repayment that would drain the company.
Common questions
The most-asked questions about Convertible Note — answered straightforwardly.
What is the difference between a convertible note and a SAFE? +
A convertible note is debt — it accrues interest, has a maturity date, and creates a balance-sheet liability. A SAFE (Simple Agreement for Future Equity) is not debt — it is a contractual right to receive equity at a future round, with no interest and no maturity date. SAFEs are simpler and increasingly preferred for early-stage rounds, but lack the debt protections (maturity, interest) that some investors prefer.
What is a valuation cap on a convertible note? +
A valuation cap sets the maximum effective valuation at which the note converts to equity, regardless of the actual price at the qualifying financing round. If a note has a $5M cap and the company raises its Series A at a $20M valuation, the note converts as if the company were valued at $5M — giving the note holder many more shares per dollar invested than the Series A investors. The cap is the primary economic protection for early investors.
Is a convertible note a loan or equity? +
Legally, a convertible note starts as debt — it's a loan with a promissory note. It becomes equity only when it converts at a qualifying financing event. Until conversion, it sits on the balance sheet as a current or long-term liability. This matters for lenders: if a business has outstanding convertible notes, a bank or SBA lender will see that liability and may ask about conversion mechanics and timeline.
Further reading
This glossary entry is educational content. ClearValue Lending is a business & personal financing platform — not a lender, broker, or financial advisor. Specific product terms vary by lender; verify with the lender or issuer before applying. See privacy policy.