Convertible Note

How a convertible note works

A convertible note is a promissory note with a conversion mechanic attached. Four terms do almost all the work.

Principal is the amount lent. Interest accrues on it, typically simple rather than compounding, and in most notes the accrued interest converts into stock alongside the principal rather than being paid in cash. Y Combinator's comparison of safes and convertible notes describes note interest as often falling between 2 and 8 percent.

Maturity is the date the note comes due. If no qualifying financing has closed, the holder can usually demand repayment, and the note is in default if the company cannot pay. Y Combinator's comparison makes the same point directly, describing the maturity date as something that can force repayment or default. In practice maturity is renegotiated far more often than it is enforced, but the leverage it creates is real.

Conversion happens on a qualifying financing, which the note defines as a priced equity round above a stated minimum size. On that event the outstanding balance converts into shares of the new preferred stock.

Price is set by the cap, the discount, or both. Written in words, the conversion price is the lower of the price implied by the valuation cap and the price implied by the discount to the new round price, and the shares issued are the outstanding balance divided by that conversion price.

Cap price = Valuation cap / Fully diluted share count used in the note

Discount price = New round price per share x (1 - Discount rate)

Conversion price = lesser of (Cap price, Discount price)

Shares issued = (Principal + Accrued interest) / Conversion price

The clause that causes the most disputes is the share count in the cap price denominator. A note that says "fully diluted" without defining whether the option pool, other outstanding notes, and unexercised warrants are included will produce two defensible answers and one argument at closing.

Variants

• Capped note, with a valuation cap and no discount.
• Discounted note, with a discount and no cap.
• Capped and discounted note, converting at whichever price is lower for the investor.
• Uncapped note with a most favoured nation clause, which lets the holder adopt the terms of any later instrument the company issues before conversion.
• Bridge note, issued between priced rounds, often with a shorter maturity and sometimes convertible at a fixed discount to the next round only.

Worked example

Suppose a company issues two notes and then raises a Series A.

Note one: $300,000 principal, $6,000,000 cap, no discount, 5 percent simple interest, issued 36 months before the round. Accrued interest is $300,000 times 5 percent times three, or $45,000. Balance at conversion is $345,000.

Note two: $200,000 principal, no cap, 25 percent discount, 8 percent simple interest, issued 18 months before the round. Accrued interest is $200,000 times 8 percent times 1.5, or $24,000. Balance at conversion is $224,000.

The Series A prices at $3.00 per share on a pre-money fully diluted count of 8,000,000 shares, which implies a $24,000,000 pre-money valuation.

Note one's cap price is $6,000,000 divided by 8,000,000 shares, or $0.75. There is no discount alternative. It converts at $0.75 and receives $345,000 divided by $0.75, or 460,000 shares.

Note two has no cap, so its price is the discount price: $3.00 times 0.75, or $2.25. It receives $224,000 divided by $2.25, or 99,555 shares.

The two investors put in $500,000 combined and receive 559,555 shares. Note one, at 60 percent of the money, takes 82 percent of the shares. That is what a low cap held for a long time does. If the Series A investors buy $6,000,000 of stock at $3.00, they receive 2,000,000 shares, and post-round fully diluted stands at roughly 10,559,555 shares. The note holders own 5.3 percent of the company for $500,000, an effective post-money valuation on their money of about $9,400,000 against the $30,000,000 post-money the new investors paid. All figures are hypothetical.

Where it shows up

The instrument itself is a convertible promissory note, usually issued alongside a note purchase agreement when there are multiple holders. The note carries the principal, the interest rate, the maturity date, the definition of qualifying financing, the conversion price mechanic, and the treatment on a change of control, which commonly gives the holder a choice between repayment at a multiple of principal and conversion.

The note reappears at the next priced round in two places. In the NVCA model term sheet, the amount raised line expressly contemplates that the total includes amounts from the conversion of SAFEs and principal and interest on bridge notes. And the pre-money valuation line defines the price per share on a fully diluted pre-money basis, which is where the question of whether converting notes sit inside or outside the pre-money gets resolved. The Post-Money Safe User Guide makes the same point about converting instruments generally, noting that where parties agree the pre-money will not include converting instruments, the new money ends up with slightly less ownership than the headline arithmetic suggests and the effective post-money valuation is higher.

On the company's balance sheet, an outstanding note is a liability, not equity, until it converts. That distinction matters for any covenant, lender, or acquirer that looks at indebtedness, and the NVCA model term sheet's protective provisions restrict the creation of debt securities above a stated threshold without preferred consent.

Notes sold in reliance on Regulation D are reported to the Securities and Exchange Commission on Form D, which has a checkbox for the type of security offered and treats debt and equity separately.

Common mistakes

• Leaving "fully diluted" undefined in the cap denominator. Whether the option pool and other outstanding notes count can move the conversion price by a wide margin, and the ambiguity surfaces at the worst possible time.
• Forgetting that interest converts. On a three-year note at 8 percent, accrued interest is roughly a quarter of the principal, and at a low cap that interest buys a disproportionate number of shares.
• Stacking notes at different caps without modelling the outcome. Each note converts at its own price, so a series of notes issued over two years at rising caps produces a conversion table nobody has looked at until the round closes.
• Treating maturity as cosmetic. It is a debt obligation. A holder who wants repayment is entitled to ask, and the company's inability to pay is a default with consequences beyond the cap table.
• Assuming the note converts into the same security the new investors buy. Many notes convert into a shadow series with the same economics but reduced or absent liquidation preference on the converted amount, and that is a negotiated point in the financing documents.
• Ignoring the change of control clause. If the company is acquired before a priced round, the note governs what happens, and a 2x repayment multiple on an early acquisition is common enough to check for.

Related terms

A convertible note is the older sibling of the safe and is used for the same job at a seed-round or pre-seed. Both convert at a series-a, priced against pre-money-valuation and post-money-valuation, and both land on the cap-table as dilution. A note is debt, which places it in the same family as debt-financing rather than equity-financing, and its conversion produces preferred-stock carrying a liquidation-preference.

Frequently asked questions

How does a convertible note convert to equity?

On a qualifying financing, the outstanding principal plus accrued interest is divided by a conversion price to produce shares. The conversion price is whichever is lower of the price implied by the valuation cap and the new round price reduced by the discount. The resulting shares are usually the same class of preferred stock the new investors are buying, or a shadow series with modified preference terms.

What is a typical convertible note interest rate?

Y Combinator's comparison of safes and convertible notes describes note interest as often falling between 2 and 8 percent. Rates vary with the market and the lender, and the interest is generally intended to convert into stock rather than to be paid in cash, so it functions more as an accrual of ownership over time than as a yield.

What happens if a convertible note reaches maturity without a priced round?

The holder can typically demand repayment, and failure to pay is a default. In practice the parties usually negotiate an extension, a conversion at a fixed valuation, or a conversion into common at the cap. The company's position in that negotiation depends entirely on how much cash it has, which is why the maturity date is the term founders most often underestimate.

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

A note is debt with interest and a maturity date and ranks senior to equity in a liquidation. A safe is not debt: Y Combinator's documents describe it as having no interest and no maturity date, sitting on par with preferred stock in seniority. Y Combinator characterises safes as the default for early fundraises and convertible notes as increasingly rare for new raises, used mostly for bridge loans and specific cases.

Which wins, the cap or the discount?

Whichever produces the lower price per share for the investor, if the note grants both. When the next round prices well above the cap, the cap wins. When the next round prices at or below the cap, the discount wins. A well-drafted note says explicitly that the conversion price is the lesser of the two.

Do convertible notes dilute founders?

Yes, at conversion. The shares issued to note holders come out of the same fully diluted pool everyone else holds, and if the notes sit inside the pre-money valuation of the next round, the dilution falls on pre-round holders rather than on the incoming investors. Whether they sit inside or outside the pre-money is negotiated in the term sheet.