Convertible Note

A convertible note is a short-term debt instrument that converts into equity at a future triggering event, typically a priced financing round, an acquisition, or an IPO.¹ It is recorded as debt on the company's balance sheet, accrues interest, and carries a maturity date — three structural features that distinguish it from a SAFE, which is not debt and has none of those terms.² In 2019, 37% of angel investment deals used convertible notes according to the Angel Capital Association's 2020 Angel Funders Report, though SAFEs have grown in popularity since — particularly for Y Combinator-backed companies.⁴

Core Structure and Terms

A convertible note has five primary terms: principal amount, interest rate, maturity date, valuation cap, and discount rate. The principal is the amount loaned. The interest rate — typically 4–8% per annum — accrues through the conversion date; the accrued interest converts into additional equity alongside the principal rather than being paid in cash.¹ The maturity date is usually 12–24 months from issuance, setting a deadline by which the company must either raise a qualified financing round or negotiate with noteholders.

The valuation cap sets the maximum pre-money valuation at which the note will convert into equity.¹ If a note has a $5M cap and the company raises its Series A at a $10M pre-money valuation, the noteholder converts as if the company were valued at $5M — receiving roughly twice the shares that Series A investors receive for the same dollar amount. The lower the cap, the more shares the noteholder receives.²

The discount rate gives noteholders a percentage reduction off the per-share price in the qualifying financing round.² A 20% discount on a round where Series A investors pay $1.00/share means noteholders convert at $0.80/share. Discounts typically range from 10–30%, calibrated to the estimated risk and time horizon of the investment.² DLA Piper notes that some notes use bifurcated discounts — for example, 10% if conversion occurs within six months and 15% thereafter — to apportion risk more precisely between investors and founders.²

Conversion Mechanics

When a qualifying financing event occurs, the note converts to preferred equity automatically. The conversion price is the lower of: (1) the price implied by the valuation cap, or (2) the discounted price based on the round price.¹ Notes that have both a cap and a discount convert at whichever yields more shares for the investor. If a note has a $5M cap and a 20% discount, and the Series A pre-money valuation is $6M at $1.00/share, the cap implies a price of approximately $0.83/share ($5M cap / 6M pre-money shares) while the discount implies $0.80 — so the note converts at $0.80.⁵

A worked example from AngelList: a founder raises $1M on a convertible note with a $5M cap and 5% interest rate. One year later, a $2M Series A closes at an $8M pre-money valuation, $10M post-money. The note principal of $1M plus $50K of accrued interest converts at the cap-implied price of $5M/$10M = 50% of the Series A price. The noteholders receive the same 20% ownership as the $2M Series A investors, despite having invested only $1.05M versus $2M.¹

Some notes specify a minimum qualifying round threshold — for example, conversion only triggers if the company raises $2M or more in the priced round. A smaller raise that falls below this threshold does not convert the note, protecting noteholders from being forced into equity at an under-capitalized valuation.¹

Comparison with SAFEs

The SAFE (Simple Agreement for Future Equity), introduced by Y Combinator in 2013, is structurally identical to a convertible note except it is not debt. SAFEs have no maturity date, no interest rate, no security interest, and no right to demand repayment.² They share the same conversion mechanism — valuation cap, discount rate, or both — but eliminate the debt overhang that can complicate a company's balance sheet and create pressure when the maturity date approaches.

Convertible notes provide investors with superior downside protection compared to SAFEs. As debtholders, noteholders sit senior to both SAFE holders and equity holders in a liquidation, are entitled to repayment of principal before equity distributions, and typically negotiate a liquidation preference of 1–3x upon an acquisition.¹ This seniority makes convertible notes preferable for investors who are concerned about downside risk — particularly at earlier stages where company failure is more likely.

For founders, convertible notes incur slightly higher legal costs than SAFEs (due to the additional terms), accrue interest that increases dilution over time, and introduce the maturity date as a negotiating pressure point.¹ SAFEs are cheaper, faster, and carry no debt on the balance sheet — which is why YC standardized on them for its portfolio companies. However, many institutional investors outside the YC ecosystem continue to use convertible notes, particularly for deals above $500K where downside protection matters more than simplicity.

What Happens at Maturity

If a company has not raised a qualifying financing round by the note's maturity date, the note technically becomes due and payable. In practice, forcing repayment would likely push an under-capitalized startup into insolvency — an outcome that serves no one.¹ Noteholders facing this situation have three standard options: extend the maturity date (often with renegotiated terms, such as a lower cap or higher discount), convert the note to equity immediately at a negotiated valuation, or in rare cases, accelerate into a formal enforcement process.¹

Maturity extensions are the most common outcome. The renegotiation of conversion terms at extension is a significant risk for founders: investors who agreed to a $5M cap during the seed round may demand a $3M cap or a 30% discount as the price of extending when the company has failed to achieve the milestones that would have produced a Series A.¹ Founders should build in runway to close a qualifying round before maturity, and should negotiate for maturity dates that are genuinely achievable — 18 months is more realistic than 12 months for most seed-to-Series A timelines.

Cap Table Implications

Multiple convertible notes with different caps, discount rates, and maturity dates create cap table complexity that can deter Series A investors.¹ When a dozen angels each hold a note with different terms, modeling the fully diluted ownership post-conversion requires individually calculating each note's conversion price — and the resulting cap table has many small stockholders with slightly different cost bases that complicate governance and information rights.

Founders who run multiple note rounds should consider harmonizing terms — using a single note template for all investors in a given financing window — or consolidating outstanding notes before raising a priced round. Series A lead investors commonly request a summary of all outstanding convertible notes and SAFEs as part of due diligence, and a fragmented note history signals poor cap table hygiene.³ The post-money SAFE structure introduced by YC in 2018 partially addresses this by fixing dilution at issuance rather than at conversion, making it easier to track ownership in real time.²

References

1. What is a Convertible Note? — AngelList Education Center(accessed Apr 19, 2026)
2. Understanding Convertible Securities: Valuation Cap and Discount — DLA Piper(accessed Apr 19, 2026)
3. Convertible Notes for Startups: Full Guide + Excel File — Breaking Into Wall Street(accessed Apr 19, 2026)
4. 2020 Angel Funders Report — Angel Capital Association(accessed Apr 19, 2026)
5. Mastering Valuation Caps and Floors in Convertible Debt Instruments — ScaleX Invest(accessed Apr 19, 2026)
6. Series Seed Convertible Note Financing Package — Cooley GO(accessed Apr 19, 2026)
7. Valuation Caps and Conversion Discounts — IPOHub(accessed Apr 19, 2026)