A convertible note is a loan an investor makes to your startup that is designed never to be repaid in cash — instead, it converts into equity at your next priced round, usually at a better price than the new investors get. That single sentence hides the catch that costs founders the most: a convertible note is debt, which means it quietly accrues interest the entire time it sits on your books, and it carries a deadline — a maturity date — that can hand the investor enormous leverage at the exact moment you are weakest. The instrument looks like a fast, friendly way to raise money before you know what your company is worth. It is. It is also a contract that can convert a 10% investment into control of your company if you sign the wrong version of it.
This guide is for the technical SaaS founder between $5M and $15M in Annual Recurring Revenue (ARR) who raised on a convertible note early — or is being offered one now — and never had the conversion math, the interest drag, and the maturity-date risk laid out in plain English. By the end you will be able to calculate exactly how many shares a note converts into, see how a valuation cap and a discount fight for the lowest price, understand why the interest you forgot about buys the investor extra equity, and know precisely when a convertible note is the right tool versus when a SAFE note or a full priced round serves you better. I will define every finance term as it appears, because this is lending and securities law wearing a startup hoodie, and nobody should nod along to “the note converts at the cap on a fully diluted, pre-money basis net of the option pool” while pretending they followed it.
This is educational, not legal or financial advice. I am walking you through how a convertible note works so you can hold an informed conversation with the people who do this for a living — not so you can paper your own round. A convertible note is a binding debt-and-securities contract, and the right structure depends on your stage, your cap table, how much you are raising, and your jurisdiction. Engage a qualified startup attorney, and run anything material past your own financial advisor before you sign.
What a Convertible Note Actually Is
Start with the word that does all the work: note. In finance, a note is a written promise to repay borrowed money. A convertible note begins life as exactly that — a loan. The investor wires you cash, and on paper you owe it back, with interest, by a stated date. What makes it convertible is a clause that says: instead of paying me back in dollars, this debt will turn into shares of your company when you raise your next real round of equity.
Here is the cleanest way to picture it. A convertible note works like a gift card that the store would much rather you spend than redeem for cash. The investor has handed you money and holds a claim. If your company succeeds and raises a priced round, that claim converts into stock — the outcome the investor actually wants, because equity in a winner is worth far more than getting their loan back. If your company stalls and never raises, the claim stays a loan, and the investor is a creditor standing in line ahead of every shareholder. The structure lets the investor capture the upside of equity while keeping the downside protection of debt.
That dual nature is the whole point, and it is worth being blunt about why investors like it. The most common security in early-stage deals is some form of debt that can convert into stock, precisely because it gives the investor the best of both worlds. In a bankruptcy, debt holders are more senior than equity holders — they get paid back before any shareholder sees a dollar. So an investor structures their money as a convertible note to sit higher in line if things go bad, then converts to equity if things go well so they can cash out on the shares. Heads they are protected; tails they win. You, the founder, are on the other side of that trade.
A few terms you will meet immediately, each defined the first time:
- Principal. The original loan amount — the cash the investor actually wires you. A “$1M note” has $1M of principal.
- Priced round. A financing where you and your investors formally agree on a per-share price and the investors buy stock outright (almost always preferred stock — shares carrying extra rights, like getting paid back first in a sale, that common shareholders do not have). The convertible note is built to convert into this round.
- Qualified financing. The specific kind of priced round that triggers automatic conversion — typically defined in the note as a preferred-stock raise above a minimum dollar amount (say, $1M or more). Below that threshold, the note may not convert at all. Hold that thought; it is a trap most guides skip, and I will come back to it.
So the investor’s money is not stock yet. It is a loan with a conversion right attached, waiting for a qualified financing to turn it into shares. The terms that decide how many shares — the valuation cap, the discount rate, the interest rate, and the maturity date — are the entire game, and they are where founders get hurt. We will take them one at a time.
The Four Terms That Decide Everything
A convertible note has four moving parts that matter. A SAFE note — the convertible note’s younger, debt-free cousin — has only two of them (the cap and the discount). The two extra parts on a convertible note, interest and maturity, are exactly what make it more dangerous and occasionally more useful. Understand all four and you understand 90% of what a note does to your cap table (the running record of who owns what percentage of your company).
A note on the numbers in this guide. The interest rates, caps, discounts, and round sizes below are illustrative examples chosen to make the math clear, not current market quotes. Real terms move with the funding climate, your traction, and your geography — a 2026 seed note looks nothing like a 2021 one. Use these to understand the mechanics and the relative effects; verify live norms with your attorney and investors before you set your own terms.
The Valuation Cap
The valuation cap is the maximum company valuation at which the investor’s money is allowed to convert into equity — a ceiling on the price they pay per share, no matter how high your next round is priced. Think of it as a reward for showing up early. The investor took the most risk by funding you before anyone knew what the company was worth, so the cap guarantees they convert as if the company were worth no more than a set number, even if you later raise at a much higher valuation.
A worked feel for it: if your note carries an $8M valuation cap and you later raise a Series A at a $24M pre-money valuation, the note holder converts as though the company were worth $8M — one-third of the round’s price. They get three times the shares per dollar that the new Series A investors get. The cap is almost always the term that costs founders the most, because it bites hardest exactly when you succeed and raise at a high number.
The Discount Rate
The discount rate gives the note holder a percentage off the price per share that the next round’s investors pay. It is the other way of rewarding early risk: instead of (or in addition to) a cap, the investor simply buys in cheaper than the people who show up at the priced round. The math is a single subtraction. If a note carries a 20% discount and your Series A investors pay $2.50 per share, the note converts at $2.00 per share ($2.50 × (1 − 0.20) = $2.00). Same shares, lower price, which means more shares for the same dollars.
The Interest Rate
This is the term that separates a convertible note from a SAFE, and the one founders most often forget to model. Because the note is debt, it accrues interest — a percentage of the principal that builds up over time as the cost of borrowing the money. On a convertible note, that interest almost never gets paid in cash. Instead, when the note converts, the accrued interest is added to the principal and the combined total converts into shares. So interest does not cost you dollars; it costs you equity. A note that accrues $90,000 of interest hands the investor another $90,000 worth of stock at conversion, on top of everything the cap or discount already gives them. Convertible-note interest rates commonly run in the low-to-mid single digits annually, but as always, that is an illustrative range, not a rule.
The Maturity Date
The maturity date is the deadline by which the note must either convert into equity or be repaid in cash — typically 18 to 24 months out. This is the sharpest edge on the whole instrument, and it has no equivalent on a SAFE. If your note matures and you have not raised a qualifying priced round, the loan is technically due, and the investor can demand their principal plus all accrued interest back in cash. Most startups cannot repay a seven-figure note on demand, which hands the investor real leverage at the worst possible moment — right when you have failed to raise and your cash is thin. What happens next is a negotiation, and the investor holds the stronger hand. We will spend a full section on this, because it is where convertible notes do their real damage.
How a Convertible Note Converts: The Full Worked Example
Numbers in isolation do not land, so let us run a complete conversion end to end, with every arithmetic step spelled out. This is the calculation your attorney or a financial model will do, and you should be able to follow every line of it. A downstream check can re-derive each number from the inputs.
The setup. You raised a $1,000,000 convertible note to bridge yourself toward a Series A. Its terms:
- Principal: $1,000,000
- Interest: 6% simple annual interest
- Time to conversion: 18 months (1.5 years)
- Valuation cap: $12,000,000
- Discount: 20%
Eighteen months later, you raise your Series A at a $25,000,000 pre-money valuation with a share price of $2.50 per share.
Step 1 — Accrue the interest. Simple interest is principal times rate times time:
Accrued Interest = $1,000,000 × 0.06 × 1.5 = $90,000
So the amount that actually converts is the principal plus that interest:
Conversion Amount = $1,000,000 + $90,000 = $1,090,000
That $90,000 is pure extra dilution the principal alone would not have caused. Founders routinely model the $1M and forget the $90K.
Step 2 — Find the pre-round share count. The round’s $2.50 price implies a number of shares already outstanding before the new money. Dividing the pre-money valuation by the price per share:
Pre-Round Shares = $25,000,000 ÷ $2.50 = 10,000,000 shares
These 10,000,000 shares are held by you, your co-founders, your team, and the option pool.
Step 3 — Price the discount path. A 20% discount off the $2.50 round price:
Discount Price = $2.50 × (1 − 0.20) = $2.00 per share
Step 4 — Price the cap path. The cap converts the note as if the company were worth $12M against those same pre-round shares:
Cap Price = $12,000,000 ÷ 10,000,000 shares = $1.20 per share
(Equivalently, the round price scaled by the ratio of the cap to the pre-money valuation: $2.50 × ($12M ÷ $25M) = $1.20. Same answer.)
Step 5 — Take the lower price. When a note has both a cap and a discount, the standard rule is simple and worth memorizing: the note converts at whichever term gives the investor the lower price per share (and therefore more shares). The investor does not stack both — they get the better of the two.
| Conversion path | Price per share | Shares the note buys ($1,090,000 ÷ price) |
|---|---|---|
| Discount (20% off $2.50) | $2.00 | 545,000 |
| Valuation cap ($12M) | $1.20 | 908,333 |
The cap price of $1.20 is lower than the discount price of $2.00, so the cap wins, and the note converts at $1.20 per share.
Step 6 — Issue the shares. Divide the conversion amount by the winning price:
Note Shares = $1,090,000 ÷ $1.20 = 908,333 shares
Step 7 — See the reward for showing up early. Compare that to what the same $1,000,000 would have bought at the round’s actual $2.50 price with no note benefits:
Naive Shares = $1,000,000 ÷ $2.50 = 400,000 shares
The note holder gets 908,333 shares instead of 400,000 — about 127% more stock for the same money, the combined effect of the cap, the discount being beaten by the cap, and the interest. That gap is the early-risk premium made concrete, and it comes out of your ownership.
Putting It on the Cap Table
Now layer the Series A on top so you can see the dilution. Say the Series A investors put in $6,000,000 of new money at the same $2.50 price, buying 2,400,000 new shares ($6,000,000 ÷ $2.50). The note’s 908,333 shares convert at the same moment. Here is the post-round cap table:
| Shareholder | Shares | Ownership |
|---|---|---|
| Founders, team, and option pool | 10,000,000 | 75.14% |
| Convertible note (converted) | 908,333 | 6.83% |
| Series A new money | 2,400,000 | 18.03% |
| Total | 13,308,333 | 100% |
Read the bottom two rows together, because they are the lesson. The note holder paid $1,000,000 and ended up with 6.83% of the company — an effective price of about $146,514 per percentage point. The Series A investor paid $6,000,000 for 18.03% — about $332,708 per point. The note holder bought ownership at less than half the price the Series A investor paid, for showing up roughly eighteen months earlier and accepting the risk. That is exactly what the cap, discount, and interest are designed to do. None of it is a scandal — it is the deal you agreed to. The scandal is only when you did not do the arithmetic and find out at conversion.
When the Discount Wins Instead
The cap does not always win. In a flat or modestly priced round, the discount can be the better deal for the investor. Suppose that instead of a strong $25M Series A, your next round came in soft — a $10M pre-money valuation at $1.00 per share (still 10,000,000 pre-round shares). Now the discount price is $0.80 ($1.00 × 0.80), while the cap price is $1.20 ($12M ÷ 10,000,000). This time the discount’s $0.80 beats the cap’s $1.20, so the note converts at $0.80 and buys 1,362,500 shares ($1,090,000 ÷ $0.80). The general pattern: in a strong, high-priced round the cap usually wins; in a flat or weak round the discount usually wins. Either way, the investor gets the lower price — you never get to hand them the higher one.
The Convertible Note’s Sharpest Edge: Maturity and Covenants
Everything above is the mechanical, agreed-upon math. The real danger of a convertible note is not in the conversion arithmetic — it is in what happens if you do not get to convert on time. This is the part of the instrument that has no equivalent in a SAFE, and it is where I have seen the structure turn genuinely predatory.
Recall the maturity date: the deadline, often 18 to 24 months out, by which the note must convert or be repaid. The optimistic founder signs a note assuming the Series A will obviously happen well before then. Then the market shifts, the round slips two quarters, and suddenly the note is maturing while you are still raising. Now the investor is owed their principal plus all accrued interest, in cash, and you cannot pay it. You are negotiating from the weakest position a founder can occupy: a creditor with a matured loan, and no money to satisfy it.
In a healthy relationship, this gets handled reasonably. Most lenders do not actually want to own and operate your SaaS company — they want a return. A reasonable note holder will say, in effect: “You are getting low on cash and your round is late. Make us more comfortable — tighten up operations, give us a revised plan — and we will extend the maturity 60 or 90 days.” They work with you, because forcing the issue helps no one. Reasonable lenders behave like partners with a deadline.
But the structure can be weaponized, and you should know what that looks like. Some investors deliberately attach covenants — performance conditions written into a debt agreement that, if breached, let the lender declare the loan in default and call it due. A covenant might require you to maintain a minimum cash balance, hit a revenue threshold, or stay above some operating metric. There are firms — and founders who have lived this will tell you about it at conferences, without naming names — that use convertible debt specifically as a takeover tool. They set the covenants tight enough that a normal, breakeven, perfectly fine business will trip one of them. The moment you do, they have the contractual right to convert on punishing terms or seize control. The intent is to put in 10% of the company’s capital as a convertible note and walk away owning 100% of the equity, by engineering a default the company was always going to hit. They never intend to work with the borrower; the goal is to foreclose and take the company for cents on the dollar.
That is the extreme. It is not the norm, and it is not a reason to refuse all convertible notes. It is a reason to read the covenants and the maturity terms with the same scrutiny you would give a personal loan secured by your house, because functionally that is what you are signing. The protective moves are concrete: negotiate a maturity long enough to comfortably reach your next round; cap the covenants to things you control and can clearly clear; build in an automatic extension or a conversion-at-a-default-valuation mechanism so a missed round does not become a cash demand; and know your investor’s reputation before you take their money. The same instinct that makes you read a term sheet line by line applies double to a note’s default provisions. Risk mitigation is a love language of investors — and it should be one of yours, too, pointed right back at the terms they hand you.
The Qualified Financing Trap Most Guides Skip
Here is a failure mode that almost no convertible-note explainer mentions, and it catches founders who did everything else right. A convertible note usually only converts automatically when you raise a qualified financing — a priced round above a minimum size written into the note, often $1M or more of new preferred stock. That threshold exists to make sure the note converts into a real, meaningful round rather than a tiny one. But it creates a gap.
Suppose your note says it converts on a qualified financing of “$2,000,000 or more,” and you manage to raise only a $1,200,000 priced round — below the bar. The note does not convert. It just keeps sitting on your balance sheet as debt, still accruing interest, still ticking toward its maturity date, while brand-new equity investors are now on your cap table. You have landed in the worst of both worlds: new shareholders and an unconverted lender still holding repayment leverage. A SAFE does not have this problem — it typically converts on any equity financing, with no minimum threshold. The convertible note’s qualified-financing floor is a real, frequently overlooked risk, and the fix is to negotiate the threshold low enough that any realistic next round clears it, plus a clear conversion mechanic for a below-threshold round.
Convertible Note vs. SAFE vs. Priced Round
A convertible note is one of three common ways to raise early capital, and choosing among them is a real decision, not a default. Each deserves equal treatment, because the right answer depends entirely on how much you are raising, how much structure you can stomach, and what the investor demands. The honest summary: SAFEs win on speed and founder safety, priced rounds win on clarity and finality, and convertible notes sit in between — useful precisely when you want debt-like seniority or a bridge, and dangerous precisely because of the interest and maturity that make them debt.
The SAFE
A SAFE (Simple Agreement for Future Equity) is the convertible note with the debt stripped out. Created by the startup accelerator Y Combinator in 2013, it is a contract for future equity that converts at your next priced round using a cap and/or a discount — exactly like a note — but it is not a loan. There is no interest accruing, no maturity date, no repayment obligation, and no covenants. That makes the SAFE meaningfully safer for the founder: nothing can come due, so no investor can use a deadline as leverage. The trade-off is that a SAFE gives the investor less downside protection, so some investors — especially more traditional or institutional ones — prefer the seniority of a note. SAFEs now dominate the earliest rounds; by some counts roughly 90% of pre-seed financings use them. For the full mechanics of caps, discounts, and stacking dilution, the companion guide on the SAFE note works the SAFE-specific math end to end.
The Convertible Note
A convertible note, covered in depth above, is debt that converts to equity. Its defining features versus a SAFE are the interest (which converts into extra shares) and the maturity date (which can force a cash repayment or a punishing renegotiation if you fail to raise in time). Reach for a note when an investor specifically wants the downside protection of being a creditor, when you are deliberately bridging between two priced rounds and want the discipline of a deadline, or when an institutional lender’s process simply requires debt. Avoid it when you could raise just as easily on a SAFE and have no need to take on a repayment obligation — the maturity risk is real cost for no founder benefit.
The Priced Round
A priced round is the grown-up version: you and your investors agree on a real valuation, fix a per-share price, and the investors buy preferred stock outright. The standardized model documents the industry negotiates from are published by the National Venture Capital Association. There is no deferral and no conversion later — ownership is settled the day the round closes. Priced rounds cost more in legal fees and take longer, but they buy you something valuable: everyone knows exactly who owns what, immediately, and there is no interest, no maturity, and no surprise stack of conversions waiting to land. The deeper terms — liquidation preferences, participating preferred stock, anti-dilution provisions — live in the term sheet and shape what you actually pocket at exit. Move to a priced round once the dollars are large enough that the dilution deserves to be visible to everyone from day one.
Side-by-Side
| Dimension | Convertible Note | SAFE | Priced Round |
|---|---|---|---|
| Legal nature | Debt that converts to equity | Contract for future equity (not debt) | Equity sold today (preferred stock) |
| Interest | Yes — accrues and converts to extra shares | None | None |
| Maturity date | Yes — repay or convert by a deadline | None | Not applicable |
| Covenants / repayment leverage | Possible — read them carefully | None | None |
| Valuation set now? | No (deferred to next round) | No (deferred to next round) | Yes — a real per-share price |
| Valuation cap / discount | Usually both | Usually both | Not applicable |
| Conversion trigger | Qualified financing (minimum size) | Any equity financing (no minimum) | N/A — it is the financing |
| Speed and cost | Fast, low cost | Fastest, cheapest | Slowest, highest legal cost |
| Dilution visibility | Hidden until conversion | Hidden until conversion | Transparent immediately |
| Repayment risk to founder | Real — the note can come due | None | None |
| Best when | Bridges, or when the investor wants debt seniority | Genuinely early, smaller raises | Larger raises where clarity matters |
The rough rule practitioners use: reach for a SAFE for genuinely early, smaller raises where speed matters and you want zero repayment risk. Use a convertible note when you specifically want debt-like seniority for the investor, are bridging between two priced rounds, or are dealing with a counterparty whose process requires debt. Move to a priced round once the dollars are large enough that the dilution deserves to be visible to everyone from the start. As the check sizes grow, the case for the priced round’s discipline grows with them.
When a Convertible Note Is the Right Tool (and When It Is Not)
Because a convertible note carries risks a SAFE does not, it is worth being precise about when it earns its place. A note is not the wrong tool — it is the wrong default. Here is how to tell the difference, and crucially, what to use instead when a note does not fit.
A convertible note fits when:
- You are bridging between two priced rounds. You have a Series A done, you need a tranche of capital to reach the milestones that justify a Series B, and you want a clean, fast instrument with a built-in deadline that pushes everyone to get the next round done. This is the classic, healthy use of a note — sometimes literally called bridge financing.
- The investor specifically wants debt seniority. Some investors — family offices, certain funds, more conservative angels — will only invest if they sit ahead of equity in a downside. If you want their money, the note is the price of admission. That is a legitimate reason to use one.
- An institutional lender’s process requires debt. Some capital sources are structurally set up to lend, not to buy equity. If that is where your money is coming from, a convertible note may be the only option on the table.
A convertible note is the wrong tool when:
- You could just as easily raise on a SAFE. If no investor is demanding debt seniority and you are doing a normal early raise, a SAFE gives you the same cap-and-discount conversion with none of the interest or maturity risk. Taking on a repayment obligation you did not need is pure downside. What is available instead: a standard post-money SAFE, which the seed round funding playbook covers in detail.
- You are raising enough that the dilution should be visible now. Once the dollars get large, deferring the valuation question stops being a feature and starts being a way to hide the cost from yourself. What is available instead: a priced Series A funding round, where the per-share price and everyone’s ownership are settled on day one.
- You actually need debt you can draw and repay flexibly, not equity. If the real problem is short-term cash flow or runway extension and you are confident in the trajectory, you may want a loan that stays a loan. What is available instead: venture debt — a loan designed for venture-backed companies that does not convert and does not reprice your equity, though it does have to be repaid on a schedule. The trade-offs there deserve their own analysis.
- You are using the note to avoid a down round you cannot actually avoid. A note that defers the valuation question can quietly set up a worse outcome than the down round you were dodging — if the next round prices low, the note’s cap, discount, and accrued interest can compound into more dilution than a clean priced round would have. Deferring the price does not make the price better; it just delays the reckoning.
The throughline is the same lens that should govern every financing decision: a known, modeled cost weighed against the value it buys. A convertible note is a perfectly responsible instrument when it solves a real problem — a bridge, a seniority requirement, a lender’s structure. It is an expensive mistake when it is just a way to put off a conversation you are going to have anyway, with interest accruing the whole time you procrastinate.
How a Convertible Note Connects to Your Exit
A convertible note is a seed- or bridge-stage instrument, but its consequences land years later, at the exit you are actually building toward. Every share the note converts into — every point the cap, the discount, and the accrued interest hand the investor — is ownership you do not have when the company sells. At a $25M to $100M+ outcome, single percentage points are large numbers. The reason to take the conversion math seriously at $1M of principal is not the $1M. It is what that dilution, plus the interest you forgot to model, compounds into across every future round and the final sale.
This is the same discipline you already apply to churn, CAC, and pricing: do the math before you sign, not after. There is a hard-won maxim for it — if you do not do the math in business, you pay the stupid tax, and a thoughtless convertible note is one of the more expensive versions of it. One number buried in a document you signed eighteen months ago — a cap one notch too low, a maturity date a quarter too early, a covenant you never read — can make a multi-million-dollar difference to you personally at the exit. The founders who navigate this well are the ones who, from the day the note is signed, can answer one question on demand: after this note converts, what do I own, and what could force it to convert early? If your finance function cannot produce that number quickly, it is a sign your equity hygiene needs a dedicated owner — often the moment a scaling company needs a real SaaS CFO. Keep a live conversion model from the first note, update it every time the terms or the round assumptions change, and the instrument stays the useful tool it is supposed to be — instead of the reason you own less of your company than you meant to when the wire finally comes in at the SaaS exit.
Common Mistakes Founders Make With Convertible Notes
The same handful of errors show up again and again, and every one of them is avoidable with a spreadsheet and a little discipline.
- Forgetting the interest converts into shares. The interest does not get paid in cash — it is added to the principal and converts into extra equity. Model the principal plus accrued interest from day one, not just the principal.
- Ignoring the maturity date until it is on top of you. A note that matures before you raise can be called due in cash you do not have. Negotiate a maturity long enough to comfortably reach your next round, and build in an extension or default-conversion mechanic.
- Not reading the covenants. Covenants are the trapdoor. A note with tight covenants and a predatory holder can convert a small investment into control. Cap covenants to things you control and clearly clear, and know your investor’s reputation.
- Missing the qualified-financing threshold. If your next round comes in below the note’s minimum conversion size, the note does not convert — it stays as interest-accruing debt alongside your new equity investors. Set the threshold low enough that any realistic round clears it.
- Treating the cap as your company’s value. A cap is a conversion ceiling for one investor, not a floor for your next round’s price. Founders who anchor their Series A expectations on an old note’s cap negotiate against themselves.
- Stacking notes without a running conversion model. Each note looks small; the sum, plus interest, plus whichever of cap-or-discount wins, is not. Update your fully diluted ownership every time you sign one.
The through-line is the same: do the math before you sign, not after. A convertible note is a small, fast, genuinely useful tool — right up until it is the reason you own less of your company than you planned, or worse, the reason you lost control of it.
Frequently Asked Questions
What is a convertible note in simple terms?
A convertible note is a loan an investor makes to a startup that is designed to convert into equity instead of being repaid in cash. It starts as debt — it carries an interest rate and a maturity date — but a clause says the loan will turn into shares at the company’s next priced round, usually at a better price than the new investors get, through a valuation cap and/or a discount. Think of it as a loan the investor would much rather convert into stock than collect back, because equity in a winning company is worth far more than the loan.
How does a convertible note convert to equity?
It converts at your next qualifying priced round. First, the accrued interest is added to the principal to get the total amount converting. Then the note’s valuation cap and discount each imply a price per share, and the note converts at whichever gives the lower price (and therefore more shares). You divide the principal-plus-interest by that winning price to get the number of shares the note buys. For example, a $1,000,000 note that accrued $90,000 in interest, converting at a $1.20 cap price, buys 908,333 shares ($1,090,000 ÷ $1.20).
What is the difference between a convertible note and a SAFE?
Both let an investor put money in now and receive equity later at the next priced round, using a cap and/or a discount. The difference is debt. A convertible note is a loan: it accrues interest that converts into extra shares, and it has a maturity date that can force repayment or a punishing renegotiation if you fail to raise in time. A SAFE is not a loan — no interest, no maturity, no repayment obligation, no covenants. SAFEs are simpler and safer for founders; convertible notes make sense when an investor specifically wants debt seniority or you are bridging between rounds.
How does interest work on a convertible note?
Because the note is debt, it accrues interest over time — a percentage of the principal that builds up as the cost of borrowing. On almost all convertible notes, that interest is not paid in cash. Instead, when the note converts, the accrued interest is added to the principal and the combined total converts into shares. So the interest costs you equity, not dollars. A $1,000,000 note at 6% simple interest held for 18 months accrues $90,000 ($1,000,000 × 0.06 × 1.5), so $1,090,000 converts into shares rather than the original $1,000,000.
What happens if a convertible note reaches its maturity date before converting?
If the note matures and you have not raised a qualifying priced round, the loan is technically due, and the investor can demand their principal plus accrued interest back in cash. Most startups cannot repay a seven-figure note on demand, so what happens next is a negotiation — and the investor holds the leverage. A reasonable investor will usually extend the maturity in exchange for some operational comfort. A predatory one may use a missed maturity, or a tripped covenant, to convert on punishing terms or take control. This is why you negotiate a long-enough maturity and read the default provisions carefully before signing.
What is a valuation cap on a convertible note?
A valuation cap is the maximum company valuation at which the note is allowed to convert into equity, regardless of how high your next round actually prices. It rewards the investor for taking early risk by guaranteeing them a low conversion price if the company’s value jumps. If your note has an $8M cap and you raise at a $24M pre-money valuation, the note converts as though the company were worth $8M — giving the investor three times the shares per dollar that the new investors get. The cap is usually the term that costs founders the most, so it deserves the most scrutiny.
Is a convertible note good or bad for founders?
Neither inherently — it depends on the terms and the situation. A convertible note is a legitimate, useful tool for bridging between priced rounds or when an investor requires debt seniority. It becomes bad for founders when it is used as a default in place of a safer SAFE (taking on maturity and interest risk for no benefit), when the covenants are predatory, or when it defers a valuation conversation that only gets harder with time. The instrument is fine; the danger is signing one without modeling the interest, the conversion math, and the maturity risk.
The principal, interest rates, caps, discounts, share counts, and valuation figures in this article are illustrative and simplified for clarity. Real notes contain variations — compounding versus simple interest, conversion-cap mechanics that include or exclude the option pool, MFN clauses, side letters, and bespoke covenants — that change the math. The examples here show the relative effects of different structures, not a template for any specific deal. This is not legal or investment advice; model your own cap table with counsel before signing anything.
