Convertible debt is a loan to a startup, documented as a convertible promissory note, that is designed to convert into equity when the company later raises a priced round. Instead of setting a valuation today, the company and investors defer it; when the round happens, the note’s principal and accrued interest convert into shares at a discount to the new investors’ price or at a price set by a valuation cap, whichever gives the investor more shares. If no round happens by the maturity date, the note is still debt that must be repaid, converted or extended.
For angels, accelerators and early founders, convertible notes remain a common way to bring in capital quickly without negotiating a full equity financing. Here is how they work and what to watch for.
Why Convertible Debt Exists
A very young company has little financial history or traction to support a valuation, yet valuation determines how much of the company an investor receives. Set it too low and founders give away too much; set it too high and experienced investors walk away or the next round becomes a down round. Convertible debt postpones that debate until a priced Seed or Series A round, when there is more data and a lead investor to set the price.
How Convertible Debt Works
- An investor lends the company money under a convertible promissory note.
- The company uses the funds for hiring, product development or operations.
- The note accrues interest, usually at a modest rate, which is typically added to the amount that converts rather than paid in cash.
- When the company closes a qualified equity financing (often defined by a minimum amount raised), the note converts automatically into the shares sold in that round, usually preferred stock.
- The investor gets a better price than new investors through a discount, a valuation cap or both.
Key Terms Investors Negotiate
- Discount. Many notes include a discount, often in the range of 10% to 25%, off the price new investors pay.
- Valuation cap. The cap sets the maximum valuation at which the note converts. Notes usually give the investor the better of the cap price or the discount price. The cap is often the most important economic term.
- Interest rate. Rates are typically modest. Accrued interest usually converts along with principal, which adds dilution.
- Maturity date. Commonly 18 to 24 months. The note should say what happens at maturity: repayment on demand, optional conversion at a set valuation, or extension with majority noteholder consent.
- Change of control. If the company is acquired before conversion, notes commonly give the investor a choice of repayment, often with a premium, or conversion at the cap.
- Priority. As debt, unconverted notes rank ahead of stockholders if the company fails, though often behind any secured lender.
A Worked Example
TechCo raises $1,000,000 from investors on convertible notes with these terms: 5% simple annual interest, a $5,000,000 valuation cap, a 20% discount and a two-year maturity. TechCo has 5,000,000 fully diluted shares outstanding.
One year later, TechCo closes a Series A at a $10,000,000 pre-money valuation. For simplicity, assume the Series A price is $2.00 per share ($10,000,000 divided by 5,000,000 shares). In practice, the share count used for pricing depends on the definitions in the note and the term sheet, including how the option pool and the notes themselves are treated.
- Amount converting: $1,000,000 principal plus one year of interest ($50,000) equals $1,050,000.
- Discount price: $2.00 less 20% equals $1.60 per share.
- Cap price: $5,000,000 divided by 5,000,000 shares equals $1.00 per share.
- Result: The cap price is lower, so it applies. The noteholders receive $1,050,000 divided by $1.00, or 1,050,000 shares, compared with 525,000 shares if they had invested $1,050,000 at the Series A price.
The example shows the trade-off clearly: early investors are rewarded for their risk, and founders absorb that dilution. Model conversions before agreeing to a cap.
Legal Considerations for Startups
1. Maturity Dates Have Consequences
If the note matures before a qualified financing, investors may be able to demand repayment, which most startups cannot afford. Negotiate a conversion option at maturity and an amendment mechanism that lets a majority of noteholders extend the date for everyone.
2. Interest and Multiple Notes Add Dilution
Interest converts into shares, and companies that issue notes over time at different caps can accumulate more dilution than founders expect. Keep a running pro forma cap table.
3. Securities Law Compliance
Convertible notes are securities. The offering needs an exemption, typically Rule 506(b) of Regulation D for accredited investors, with a Form D filed with the SEC and a notice filing in California and other states where investors reside. Raising from non-accredited investors, or advertising the raise, triggers additional requirements. See our posts on California Form D filings and raising capital without SEC registration.
4. California Lending and Interest Rules
Because a note is a loan, California usury and lender licensing rules can come into play depending on the lender, the rate and the terms. Keep interest rates modest and get advice if an investor is making many loans or the note carries unusual economics.
5. Tax Points
For the qualified small business stock exclusion, the holding period generally starts when the note converts into stock, not when the loan was made. Investors who care about that timing sometimes prefer SAFEs or priced equity.
Convertible Notes vs. SAFEs
Many early rounds now use SAFEs, which convert like notes but are not debt: they have no interest or maturity date. Notes still appear when investors want creditor protections or when a bridge round precedes a priced financing. Our post on convertible notes and SAFEs compares the two.
The Takeaway
Convertible debt lets startups raise early capital quickly while deferring valuation, and it rewards early investors through caps and discounts. Founders should focus on the cap, model dilution, plan for maturity, and file the required securities notices. A well-drafted note avoids disputes when the priced round arrives.
Frequently Asked Questions
What happens if a convertible note reaches maturity without a financing?
The note becomes due, so investors may be able to demand repayment. Many notes let investors convert at a preset valuation instead, and most allow a majority of noteholders to extend the maturity date. In practice, companies usually negotiate an extension or conversion rather than repay.
Do investors get both the discount and the valuation cap?
Usually not both at once. Most notes give the investor whichever produces the lower conversion price, and therefore more shares, at the time of the financing.
Is accrued interest paid in cash?
Generally no. Accrued interest is usually added to the principal and converts into shares at the same price, which increases the investor’s ownership.
Do I need to file anything when I issue convertible notes?
Usually yes. Convertible notes are securities, so companies relying on Regulation D typically file a Form D with the SEC within 15 days after the first sale and make state notice filings, including in California when California investors participate.
How Sutter Law Can Help
We prepare and negotiate convertible note financings, bridge rounds and the Series A financings that convert them. Learn more about our business financing practice, or contact us for a free consultation.
This article is general information, not legal advice. Reading it does not create an attorney-client relationship.
