The Ultimate Guide to Convertible Notes for Startups

This guide to convertible notes covers not only the basic mechanics of convertible notes, but also offers perspective on when a convertible note may be suitable for a startup and when other structures might be more appropriate for fundraising. Along the way, we highlight the important differences between convertible notes and SAFEs, as well as differences between convertible notes and priced rounds.

As we’ll learn, convertible notes can be helpful tools for early stage startups to raise money. But, as with any tool, if they are misused they can cause real harm.

• What is a Convertible Note and How Does it Work?

• How do Discounts and Valuation Caps Work?

• What Happens to the Convertible Note if There Isn’t a Priced Round?

• What Happens to the Convertible Note if There Is an Acquisition?

• When Should You Use a Convertible Note and When Should You Not?

• What’s the Difference Between a Convertible Note and a SAFE?

• How Industry and Geography May Drive Use of Convertible Notes vs. SAFEs

• What’s the Difference Between a Convertible Note and a Priced Round?

What is a Convertible Note and How Does it Work?

A convertible note is a type of debt instrument that can convert into equity of a startup. While the SAFE has become perhaps a more popular way for early stage startups to raise money, the convertible note is still commonly used for this purpose, as well as for bridge financings for more mature startups.

Related Post: The Ultimate Guide to SAFEs for Startups

When a startup sells a convertible note to an investor, it is effectively taking a loan from the investor, as opposed to selling equity in the company to the investor at a fixed price per share. As debt, convertible notes will contain an interest rate and a maturity date. But unlike a traditional loan, where the lender’s expected return is from interest, convertible note investors have greater ambitions for their loan.

Investors want the loan to convert into preferred equity in the startup, which happens when the startup raises a qualified priced round. The shares of preferred equity that the note investors receive will be the same as those sold to the new investors in the priced round, though note investors may effectively receive a better deal than the new investors if their notes convert at a discount or a valuation cap. These terms are important and subject to negotiation with investors so we take a closer look at each below.

How do Discounts and Valuation Caps Work?

Discount

A discount in a convertible note is meant to compensate investors for the higher risk involved in investing at a very early stage or at a time of need for the company (in the case of a bridge loan). It gives convertible note investors a percentage discount on the price per share new investors in a priced round will pay for their shares. 10-20% is a common discount range but it can vary.

Example: If a convertible note investor has a 20% discount and the new investors purchase preferred shares at $5 per share, the convertible note investor would only pay $4 per share. This gives the convertible note investor greater purchasing power with the amount they invested in the note.

It is less common for convertible notes to have only a discount than to have only a valuation cap. Discount only notes tend to be seen as company-friendly. And many investors refuse to invest on a convertible note without a valuation cap (unless the startup has lots of leverage). So odds are good you will have to deal with valuation caps.

Valuation Cap

The valuation cap in a convertible note is where most of the negotiation occurs between founders and investors. Like the discount, the valuation cap is meant to compensate investors for the risk they take in investing at an early stage. Unlike the discount, though, a valuation cap effectively sets a ceiling at which a convertible note will convert into equity. An example helps illustrate this.

Example: If a convertible note had a $5 million valuation cap and the startup then raised a Series A round at a $10 million valuation, the price per share for the convertible note investor would be determined using the $5 million cap, rather than the price per share paid by the investors. There’s some math involved here, but in this scenario, the price per share for the convertible note investors would likely be around half of the price per share for the new investors. Put differently, the cap would function like a whopping 50% discount!

The above example illustrates the risk to startups of raising with a low valuation cap. If the valuation of the next priced round significantly exceeds the valuation cap, the convertible note investors are effectively getting discounts that no startup would ever agree to in a discount only note. This can unreasonably skew ownership in favor of early investors to a degree that’s disproportionate to their investment. Put more plainly, they’re rewarded too handsomely for their willingness to invest at an early stage.

So, how to avoid this? Founders should think about the valuation cap relative to the expected valuation of the company at its next priced round. So if the company plans to raise a $5 million priced round at a $25 million post-money valuation, it would not be wise to sell convertible notes with a $5 million cap. However, if a company instead planned to raise a $1 million priced round at a $6 million post-money valuation, then it would be perfectly reasonable to sell convertible notes with a $5 million cap. In short, valuation caps should be viewed as a hedge to secure both the company’s and the investor’s expected valuation at the next priced round, and not merely as a windfall for investors.

A final clarifying point on discounts and caps: investors do not get to apply both the discount and the valuation cap if both are present in their convertible note. Instead, they choose the mechanism that results in the best conversion economics (i.e., the lowest price per share) for them when the notes convert into equity.

What Happens to the Convertible Note if There Isn’t a Priced Round?

The primary goal for startups and investors is for convertible notes to convert into equity when a qualified financing (i.e., a priced round above a certain dollar amount set out in the convertible note) takes place. But it’s sometimes the case that the startup fails to raise a qualified financing prior to the maturity date of the convertible notes. In that case, there are several different things that can occur.

First, the investors could demand repayment of the convertible note loans. This could happen if the investors have lost faith in the company and the company had sufficient cash reserves to actually repay investors. Because startups typically do not have much cash on hand, investors may not stand to gain much by demanding repayment.

Second, the company and investors could agree to extend the maturity date, in effect buying the company more time to raise a qualified financing. Investors may seek concessions from the company in exchange for doing this.

Third, the notes could automatically or by agreement convert into shares of common stock. The notes would only automatically convert into common stock if provided for in the note. Investors are usually reluctant to have their note convert into common stock upon maturity. Investors want their notes to convert into shares of preferred stock in a qualified financing. And failing that, investors typically prefer to keep the note outstanding, as debt sits higher in the liquidation priority stack than does common stock.

What Happens to the Convertible Note if There Is an Acquisition?

If a startup is acquired while convertible notes are outstanding, there are typically two possible outcomes for the convertible note holders, depending on the terms of the notes.

The first is a cash payment consisting of the principal and interest of the note and often a multiplier of that principal and interest, e.g., a 2x or 3x multiplier. This is often the outcome where the startup is struggling to raise money or gain traction and is acquired in lieu of shutting down, in which case the investors take their liquidation preference.

The second possible outcome is a cash payment determined as if the notes were converted into common stock at a set price, typically tied to a monetary cap set out in the notes. This outcome is more likely when the startup is acquired on more favorable terms to the startup. In such a scenario, the acquisition value is high enough that the investors will make more by converting into common stock and sharing in the acquisition proceeds than they would by taking their liquidation preference.

When Should You Use a Convertible Note and When Should You Not?

When to Use Convertible Notes

The main virtues of convertible notes are that they’re relatively fast and inexpensive. In effect, they allow the company and investors to defer much of the intensive structuring and negotiating terms to the next equity financing. As you would expect, they tend to be most useful when the startup is raising money for the first time and needs to get that money quickly in order to start growing, or in the case where a more mature startup needs a bridge loan to reach its next priced financing round.

Another convenient feature of convertible notes is that it’s easier to sell notes on a rolling basis, meaning that the company doesn’t have to have all of its investors lined up before it can close the financing. For instance, a startup could sell a $100,000 note to Investor A in March, sell a $50,000 note to Investor B in April, and sell a $75,000 note to Investor C in May. Wrangling investors to close simultaneously can take a lot of time and effort, and the convertible note structure can allow startups to sidestep this hurdle.

Another useful feature of convertible notes relates to voting rights and control. Convertible note holders are not stockholders and do not have voting rights. And it’s unusual, though not unprecedented, for convertible note investors to be given a seat on the board of directors. This is generally a good thing for early stage startups, which tend to benefit from operational flexibility in the early days of the company.

When to Avoid Convertible Notes

For a startup, it’s best to avoid convertible notes if you can get equivalent terms using a SAFE. Since SAFEs are not debt instruments, there’s no risk of investors weaponizing them as they may be able to do with convertible notes due to features like the maturity date (this is discussed in more detail in the next section). What’s more, SAFEs tend to be even faster and cheaper to close than convertible notes. Given these things, SAFEs tend to be more startup-friendly than convertible notes.

It may also be best to avoid using convertible notes when a startup has a lead investor, is raising a substantial amount from investors, and can agree on a reasonable valuation for the financing. In that scenario, it very likely makes more sense to go through the additional time and expense to price the round. Doing so locks in these reasonable terms for both the startup and the investors, rather than pushing it out into the unknown future.

Related Post: The Ultimate Guide to Raising a Priced Round for Startups

What’s The Difference Between a Convertible Note and a SAFE?

Convertible notes and SAFEs are similar in the sense that they both allow startups and investors to defer valuing the company, and they both tend to be faster and cheaper to close than a priced round. SAFEs are usually even faster and cheaper to close than convertible notes, as there’s been more standardization with the SAFE than with convertible note templates, but the differences here are likely not significant.

The big difference between convertible notes and SAFEs is that convertible notes are debt, while SAFEs are not. As debt instruments, convertible notes have an interest rate and a maturity date, i.e., a date on which the principal investment amount plus interest must be repaid.

It should be mentioned that the goal for convertible note holders is for their debt to convert into equity prior to the maturity date. In that sense, their goals are the same as SAFE holders. Everyone is aiming for that next priced round where they can finally convert into preferred equity. But the presence of the maturity date gives convertible note holders more leverage than SAFE holders. If a startup fails to raise a priced round prior to the maturity date, the convertible note holders could force the company to repay the principal and interest. Early stage startups don’t hold onto excess cash, and so this could effectively bankrupt the company. Since that wouldn’t serve the interests of convertible note holders, a more likely scenario is for convertible note holders to use the threat of the maturity date to negotiate more favorable terms for themselves in exchange for pushing out the maturity date.

Convertible notes also sit higher in the liquidation stack than SAFEs do. This is again because convertible notes are debt, and debt gets paid before equity (SAFEs are treated as preferred equity for this purpose).

All other things being equal, SAFEs are more startup-friendly than convertible notes. But convertible notes are not necessarily a bad option for startups to consider, particularly if investors insist on their use. What’s most important with either type of convertible instrument, be it a SAFE or a note, is that the core terms be reasonable.

How Industry and Geography May Drive Use of Convertible Notes vs. SAFEs

Based on 2023 data from CARTA, whether a company raises money using convertible notes or SAFEs may depend, at least in part, on that startup's industry.

(Chart from Carta Data Minute, dated June 15, 2023)

The CARTA data show that certain industries like medical devices, hardware, and biotech favor convertible notes, while software-based industries favor SAFEs.

In addition to industry, geography plays a role. Startups hubs like Silicon Valley/Bay Area, New York, and Seattle are more likely to adopt SAFEs than regions with less startup activity, which tends to favor convertible notes.

There could be a few reasons to help explain these differences. Investors (and their lawyers) in industries like hardware and biotech, for example, may be more familiar with the concept of convertible notes. These investors may also have a lower risk tolerance than software investors in startup hubs where risk taking is more promoted. Also, the SAFE was created by Y Combinator, a startup accelerator that disproportionally funds software in coastal startup hubs, areas where SAFEs are more prevalent. Finally, industries like hardware and biotech are typically more capital-intensive with business assets that are more likely to be tangible and able to be sold in a liquidation than SaaS software companies, which contributes to favoring convertible notes over SAFEs.

These factors serve as a reminder that while a startup may have a preference for, say, using SAFEs, they should also be aware of what type of investment instrument their target investors will expect to see and be prepared to adapt as needed.  

What’s the Difference Between a Convertible Note and a Priced Round?

The technical difference between a convertible note and priced round is the time at which the startup gets valued. In a convertible note financing, the startup and the investors defer valuation of a startup until a priced round. In a priced round, the startup and the investors actually set the valuation of the startup and the startup sells preferred shares to investors at a fixed price per share based on that valuation.

Related Post: The Ultimate Guide to Raising a Priced Round for Startups

As such, using convertible notes effectively allows the company and investors to defer much of the intensive structuring and negotiating terms for selling preferred shares in a priced round, as well as due diligence. And so the main difference between selling convertible notes and selling preferred shares in a priced round is that with the latter, you’re now having to commit to the sometimes laborious and inevitably more costly process of pricing the round and everything that goes into that.

What are you getting in return for this? Well, ideally you’re getting access to greater amounts of capital and from more prominent investors. That kind of capital from those kinds of investors will insist on crystal clarity surrounding their ownership stake, their rights, and their protections. They’ll also want to vet the company carefully to ensure they’re money is going toward building on a solid foundation.

What does this mean in plain terms? Mostly it means many more pages of documentation and much more vetting of the company via due diligence. The agreements for a Series A will easily be more than 10 times the length of the typical convertible note paperwork. And investors in a Series A will almost certainly take a much closer look at the company’s operational history, corporate governance, securities compliance, IP ownership, and much, much more in due diligence. The diligence done in early stage convertible note financings is often orders of magnitude less than at a proper priced round.

Given the more intensive process, priced rounds typically occur only after a startup has established some market validation and track record of revenue and growth.

Takeaways

Convertible notes have ceded ground to SAFEs in early stage financing in recent years, but they remain an important fundraising tool in early stage and in bridge financings. While they are less standardized than SAFEs this can actually be a good thing, as startups tend to be more thoughtful about the terms being negotiated.