Convertible notes

A convertible note is a short-term loan from investors to the company that is designed to be repaid in shares rather than cash. When the company raises a qualifying priced round, the amount owed (principal plus accrued interest) converts into the new preferred stock, usually at a discount to the new investors' price or at a price set by a valuation cap. Notes were the standard seed instrument in the U.S. before SAFEs, and they are still common, particularly for bridge rounds between priced rounds and in places where SAFEs are less familiar.

Because a note is debt, it carries things a SAFE does not: interest, a maturity date and a creditor's place in line. Those are where most of the surprises come from.

The terms

Worked example: conversion with interest and a cap

Our example company (10,000,000 fully diluted shares, of which 600,000 are unissued pool) issues $1 million of convertible notes with 6% simple annual interest, a 20% discount and a $9 million valuation cap. Eighteen months later it raises a $6 million Series A at $24 million pre-money, with a 10% option pool after the round.

1. Amount owed. $1,000,000 × (1 + 6% × 18/12) = $1,090,000. The $90,000 of interest converts too.
2. Series A price. The note shares and the pool increase (931,992 shares) are in the pre-money, so the price is $24,000,000 ÷ 12,255,932 = $1.9582.
3. Discount price. $1.9582 × (1 − 20%) = $1.5666.
4. Cap price. We treat the cap as pre-money and divide it by the pre-round fully diluted shares including the pool increase but excluding the notes: $9,000,000 ÷ 10,931,992 = $0.8233.
5. Conversion. The cap price is lower, so the notes convert at $0.8233: $1,090,000 ÷ $0.8233 = 1,323,940 shares of Series A preferred.

Had the Series A been priced lower, at $10 million pre-money, the round price would have been $0.7806 and the 20% discount would have beaten the cap: the notes would have converted at $0.6245 into 1,745,396 shares. Either way, the noteholders get the better of the two prices.

Maturity: the clause that bites when things are slow

A note that reaches maturity without a qualified financing is a debt that is due. In practice, noteholders who invested to get equity rarely want to force repayment from a company that cannot pay, so the usual outcomes are:

• Extension, by an amendment signed by the required majority of noteholders, sometimes in exchange for better terms (a lower cap, a higher discount).
• Conversion at maturity, if the note provides for it: into common or preferred stock at a stated valuation, often the cap.
• Repayment, if the company has cash and wants the notes gone.

The risk for founders is leverage: a noteholder majority at maturity can demand concessions at the moment the company is weakest. Long maturities (24 months or more), a clear conversion-at-maturity mechanism and majority amendment rights all reduce that risk. These points are all negotiable; check what your note actually says.

Being debt: sale, shutdown and the balance sheet

• In a sale before conversion, noteholders are creditors and are paid before any stockholder, including SAFE holders and preferred stock. Many notes also give them a premium (for example, twice the principal) or the option to convert at the cap if that is worth more.
• In a shutdown, noteholders rank with other creditors ahead of all equity. YC's SAFE guide points out the practical consequence: issuing both notes and SAFEs gives two groups of early investors different priority, which is why it advises against mixing them.
• On the balance sheet, notes are liabilities. That can matter for bank covenants, for some government grant eligibility tests that look at debt, and for how the company looks to an acquirer.
• Securities and lending law: a note is still a security, sold under the same exemptions as a SAFE (see US securities law). Interest rates are low enough that usury limits are rarely an issue, but the governing law clause matters.

How much does interest add?

Interest converts into shares, so it is real dilution. Simple interest at 6% for 18 months adds 9% to the amount converting; at 8% for two years, 16%. Compared with a SAFE on the same cap, the note therefore converts into proportionally more shares, and the gap widens the longer the priced round takes. Our SAFE vs note calculator shows the difference for your own numbers.

Extra amount converting, as a percentage of principal. Compound interest would add slightly more.

When founders still choose notes

• Bridge rounds between priced rounds, where existing investors lend to extend runway until the next round and expect a short life.
• Investor preference: some angels and funds prefer a creditor's position and a maturity date that forces a conversation.
• Outside the U.S., where SAFE-like instruments may be unfamiliar or treated differently for tax or company-law reasons and local convertible loan agreements are the norm.

For a first round with no special reason to use debt, most U.S. startups now use post-money SAFEs. The side-by-side comparison is on SAFE vs convertible note.

Sources

1. Post-Money Safe User Guide, Y Combinator. Cited for facts; not reproduced.
2. Model Legal Documents (term sheet, certificate of incorporation, investors' rights, voting and ROFR/co-sale agreements), National Venture Capital Association. Cited for structure; not reproduced.