How do convertible notes work?

An investor lends money to a startup under a note that accrues interest and has a maturity date. At the company's next qualified equity financing, principal plus accrued interest converts into shares, usually at a discount to the round price or at a valuation cap, whichever gives the investor the lower price.

What happens if a convertible note reaches maturity?

If no qualified financing has occurred, the note is due. Common outcomes are an extension agreed with holders, conversion at a stated valuation if the note provides for it, or a repayment demand, which gives note holders leverage because few early-stage companies can repay.

What is the difference between a convertible note and a SAFE?

A convertible note is debt with interest and a maturity date, making holders creditors until conversion. A SAFE is not debt, has no interest or maturity, and generally uses standardised forms. Both convert into equity at future rounds using caps and discounts.

Is interest on a convertible note paid in cash?

Usually not. In most startup notes, interest accrues and converts into additional shares along with the principal at the qualified financing. It may still have tax consequences for the company and investor, so both should confirm treatment with a tax adviser.

How Convertible Notes Work

A convertible note is a loan from an investor to a startup that is designed to convert into equity rather than be repaid. It accrues interest, has a maturity date, and converts into shares at the company's next qualifying equity financing, usually at a discount to the round price or at a valuation cap, with accrued interest converting as well.

The mechanics

Principal. The amount invested, which is legally a loan to the company.

Interest. Accrues at a stated annual rate. In most startup notes, interest is not paid in cash; it adds to the amount that converts into shares.

Maturity date. The date by which the note must convert or be dealt with. Maturities of one to two years are common.

Qualified financing. The equity round that triggers automatic conversion, usually defined by a minimum amount of new money raised, so a tiny round cannot force conversion.

Conversion price. Principal plus accrued interest converts at the lower of:

the round price reduced by a discount, or
a price based on a valuation cap.

Change of control. If the company is acquired before conversion, notes usually give the holder a choice between repayment, often with a premium, and conversion at the cap.

Security. Most startup notes are unsecured, although they rank ahead of equity holders as creditors.

A worked view of interest: principal of 250,000 accruing simple interest for eighteen months converts as principal plus that interest, so the holder receives shares for more than they originally invested.

Discount and cap together

When a note has both, calculate the conversion price each way and use the lower one. A discount helps investors most when the round price is modest; a cap helps most when the round is priced well above the cap. Founders should model both outcomes at plausible valuations.

What happens at maturity

The maturity date is where notes differ most from SAFEs.

If no qualified financing has happened by maturity, the note is due. In practice, several outcomes are possible depending on the note's terms and the investors' willingness:

Extension. Investors agree to push out the maturity date, sometimes in exchange for improved terms. This is the most common outcome when the company is progressing.

Conversion at maturity. Some notes allow or require conversion into common or a designated series of preferred stock at a stated valuation if maturity arrives without a financing.

Repayment demand. Holders can demand repayment of principal and interest. Few early-stage companies can repay, so this gives note holders significant leverage in negotiations and, in a distressed situation, a claim ahead of equity.

Amendment by majority. Many notes let a specified majority of note holders amend terms for all holders, which prevents one holder from blocking an extension.

Founders should know exactly what their notes say about maturity before signing them, and should raise with enough runway that maturity does not coincide with a difficult fundraising period.

Interest and tax

Because a note is debt, accrued interest may have tax consequences for the company and investor even when it is not paid in cash. Terms and treatment vary, so both sides should take tax advice.

Convertible notes versus SAFEs

What they share. Both defer valuation to a future round, convert into shares at a cap, a discount, or both, and are quicker and cheaper than a priced round.

What differs.

Debt status. Notes are loans; SAFEs are not. Note holders are creditors until conversion.
Interest. Notes accrue it, increasing the shares issued on conversion. SAFEs do not.
Maturity. Notes have a deadline that creates repayment rights. SAFEs have none.
Documentation. SAFEs follow widely used standard forms. Notes vary more between law firms and investors.
Regulatory treatment. Lending rules, usury limits, and the treatment of debt on the balance sheet can apply to notes in some jurisdictions.

When notes are used. Investors who want creditor protection, markets where SAFEs are less familiar, bridge financing between priced rounds, and situations where a later financing is expected soon. Bridge notes from existing investors between a Series A and Series B are a common example.

Model both. Whichever instrument is used, add it to the cap table model with interest where relevant, and run conversion at realistic round valuations.

This page is general information, not legal, tax, or investment advice. Terms and rules vary by jurisdiction and deal; get advice from counsel on a specific decision.

This is general information, not legal advice, and reading it does not create an attorney-client relationship. Talk to a qualified attorney about your specific situation.

Frequently asked questions

How do convertible notes work?: An investor lends money to a startup under a note that accrues interest and has a maturity date. At the company's next qualified equity financing, principal plus accrued interest converts into shares, usually at a discount to the round price or at a valuation cap, whichever gives the investor the lower price.
What happens if a convertible note reaches maturity?: If no qualified financing has occurred, the note is due. Common outcomes are an extension agreed with holders, conversion at a stated valuation if the note provides for it, or a repayment demand, which gives note holders leverage because few early-stage companies can repay.
What is the difference between a convertible note and a SAFE?: A convertible note is debt with interest and a maturity date, making holders creditors until conversion. A SAFE is not debt, has no interest or maturity, and generally uses standardised forms. Both convert into equity at future rounds using caps and discounts.
Is interest on a convertible note paid in cash?: Usually not. In most startup notes, interest accrues and converts into additional shares along with the principal at the qualified financing. It may still have tax consequences for the company and investor, so both should confirm treatment with a tax adviser.