What is Convertible Note?

A convertible note is a loan that converts into equity during a future funding round. It lets startups raise money quickly without negotiating a valuation - the conversion price is based on the next round.

Key terms:

• Discount: Converts at 10-25% below next round price
• Valuation cap: Maximum valuation for conversion (protects early investors)
• Interest rate: Typically 2-8%, accrues and converts to equity
• Maturity date: When the note must be repaid or converted

Example: $500K note with 20% discount and $10M cap. Series A at $15M valuation. Investor converts at $10M cap (better than $12M with discount), getting 5% ownership instead of 3.3%.

Alternatives: SAFE (Simpler Agreement for Future Equity) - similar but no interest or maturity date.

Cap and discount mechanics: The valuation cap sets a ceiling on the conversion price, ensuring early investors benefit if the company's valuation soars by the next round. The discount provides a percentage reduction off the next round's price, rewarding investors for the additional risk of investing earlier. When both a cap and discount apply, the investor typically converts at whichever term yields more shares. Convertible notes are generally preferable to priced rounds when speed matters, legal costs need to stay low, or when a fair valuation is difficult to establish at an early stage. Their evolution led to Y Combinator's creation of the SAFE in 2013, which eliminates the debt component entirely - no interest accrual, no maturity date, and simpler legal documentation. SAFEs have since become the dominant instrument for pre-seed and seed fundraising in Silicon Valley and beyond.