Easy Guide to Convertible Notes and How they Work

A Convertibles Note is a short term loan commonly used to raise funding by startups. 

They are simple, but just like with anything relating to equity, there’s a lot of confusion and misunderstanding about how they work and there are aspects that aren’t so “simple”. 

The Basics

What Is It?

Convertible Note is a legal document that is nothing more than a loan with a twist. It’s just like a regular loan with an interest rate and maturity. 

The twist is that the investor has the option to convert the loan and the accrued interest into an equity stake in the company.  

What Are the Standard Terms?

Usually the interest rate ranges between 8% and 10%. The loan is typically payable within 2 or 3 years. 

What's the Alternative?

The alternative to a Convertible Note (or Convertible Debt) is a Simple Agreement for Future Equity (“SAFE”). 

A SAFE is also used as a vehicle to raise funding by startups, except they are neither loans nor equity, they are just a legal promise for future equity. 

Why Do Convertible Notes Exist?

Delay Valuation


Convertible Notes allow investors and founders to DELAY the question of valuation.

Startups are very difficult to value in the early stages.

Investors and founders can rarely agree on a valuation so convertible notes are used as a bridging instrument to allow the company more time to grow while making sure it has the capital it needs in the form of a loan. 


Investor Protection


Convertible Notes allow additional protection to investors from the risks of investing in a startup.

Investing in startups is risky, so the investment is structured as a loan rather than a purchase of an equity share in the business.

Loans are inherently safer for investors because they have preferential treatment in case the startup fails.


Is it Really Safer?

In reality, the structure of a loan in this instance is barely safer than a SAFE or an Equity purchase. 

Why? 

Because most Convertible Notes are rarely guaranteed by the founder so if the startup fails, there’s few to no assets the investor can go after to recoup their money. 

The “Valuation Cap”

If you’ve had the pleasure of reading or maybe even using a Convertible Note you’ll know that it does have a Valuation Cap. And it’s often thought of as the Value of the business. In fact, both SAFEs and Convertible Notes often have Valuation Caps. 

Investor Can Get a Lower Price than Valuation Cap

However, Valuation Caps are NOT the value of the company. Valuation Caps are the implied MAXIMUM that the investor and founder agree is the value of the company. 

At the conversion, the Convertible Note  will convert into equity (given the investor chooses that option) at a valuation no higher than the valuation cap, but if the value comes in below that (what is referred to as a “down round”) then the original investment plus accrued interest will convert at the lower value. 

This way the investor ensures the best price. 

When Does the Convertible Note convert to equity?

The Triggers

The legal documents usually include a conversion trigger. 

In convertible notes, there are usually two triggers: 

  1. A financing round and 
  2. maturity of the loan

Financing Round

The financing round usually has to be “qualified financing” round. That just means that it has to be big enough. Sometimes that’s defined by a specific dollar value and sometimes it’s a very vague definition. 

At that point the valuation is a combination of multiple investors opinions. 


Maturity of the Loan

If the financing round doesn’t take place before the maturity of the loan, the maturity itself is the trigger event. 

At this point, the investor gets to choose whether they want to convert to equity or cash out. 

What happens if the startup can’t pay off the loan?

Often cashing out a Convertible Note isn't an option because, unless the startup was preparing to pay off the loan, there’s rarely enough cash. 
The loan is technically in default in these situations. But the company often continues to operate. In those instances, the investor and founder negotiate and the common solution is to extend the loan for another year or two. 

The investor has all the right to default the company, but since that doesn’t serve the investors interests, that rarely happens.