Convertible Notes for Startups: Caps, Discounts and Maturity

A convertible note is a short-term loan from an investor that converts into equity when your startup raises a priced round. It is debt, not equity, so it accrues interest and carries a maturity date, unlike a SAFE. Founders use it to raise money quickly without setting a valuation today.

What Is a Convertible Note, Really?

A convertible note is debt with an equity kicker. An investor lends your company money under a promissory note, and instead of being repaid in cash, that loan converts into shares of preferred stock at a later financing. You are borrowing, not selling stock, on day one.

This matters because the moment you take the money, you owe it. The obligation exists even if your company never raises again. That debt character is the single biggest difference from a SAFE, which is not a debt instrument at all.

The appeal is speed and valuation deferral. You skip the negotiation over how much your seed-stage company is worth - a conversation that is mostly guesswork at the pre-revenue stage - and promise to price it later when a real priced round forces the issue.

Why Do Founders Use Convertible Notes Instead of a Priced Round?

A priced seed round forces you to set a valuation, hire a lawyer to draft a full equity financing, and negotiate board seats and protective provisions. For a first raise of a few hundred thousand dollars, that overhead can eat 5 to 10 percent of the round in legal fees.

A convertible note closes with a much lighter document set. You sign a note purchase agreement and the notes themselves. There is no cap table repricing, no 409A valuation triggered yet, and no preferred stock terms to negotiate.

The trade-off is that you are kicking the valuation can down the road. When the notes convert, the terms you agreed to - cap, discount, interest - determine the effective price your earliest investors pay, which can be dramatically lower than your Series A price.

What Are the Four Core Terms of a Convertible Note?

Every convertible note turns on four levers. Understand these and you understand the instrument.

• Valuation cap - the maximum company valuation at which the note converts. It protects the investor if your next round is priced high.
• Discount rate - a percentage (commonly 10 to 25 percent) off the price per share in the qualified financing, rewarding early risk.
• Interest rate - the note accrues interest (typically 4 to 8 percent annual) that also converts into equity.
• Maturity date - when the loan comes due, usually 18 to 24 months out, with no automatic equity conversion if no round happens.

The cap and discount rarely both apply in full. The investor usually gets the better of the two economically - the lower effective price - at conversion. Interest is the quiet term: it is small in dollars but adds to the principal converting.

How Does the Valuation Cap Work?

The valuation cap sets a ceiling on the price the investor pays. If your qualified financing values the company at $20 million but the note has a $6 million cap, the investor converts as if the company were worth $6 million, not $20 million. They get shares at roughly one-third the price.

Without a cap, an early investor who backed you at a $1 million pre-revenue bet could be forced to convert at your $50 million Series A price - a terrible outcome for them and a signal that scares future angels off. The cap is what makes the note investable.

For the founder, a low cap is expensive dilution. Every dollar of cap headroom you give away is equity you could have kept. The cap is the term you should negotiate hardest.

What Is the Discount Rate and How Is It Different from the Cap?

The discount is a straight percentage reduction on the round price, independent of valuation. A 20 percent discount means the investor pays 80 percent of what the new Series A investors pay per share.

The cap and discount interact. At conversion, the note converts using whichever mechanism gives the investor more shares - the lower effective price wins. If the cap math yields a cheaper price than the discount math, the cap governs, and vice versa.

In early, low-valuation rounds the discount often binds. In high-valuation rounds the cap binds. That is why sophisticated angels push for both: one protects against a modest round, the other against a blowout.

How Does a Convertible Note Convert at a Qualified Financing?

1. The company closes a priced round that clears the qualified financing threshold written into the note.
2. Accrued interest is added to the principal to give the total conversion amount.
3. The conversion price is calculated as the lower of the cap price and the discounted round price.
4. The conversion amount is divided by the conversion price to give the investor's share count.
5. Those shares are issued, usually as preferred stock, and the note is cancelled.

A "qualified financing" is a priced equity round above a set threshold, typically $1 million raised. When it closes, every outstanding note automatically converts into the same preferred stock the new investors receive, at the better of the cap price or the discounted price.

The mechanics are mechanical, not negotiated at the time. Your counsel runs the conversion math, the note principal plus accrued interest becomes shares, and the investor joins the cap table as a preferred shareholder with the new round's rights.

One subtlety: because interest accrues, the converting principal is slightly larger than the cash invested. A $100,000 note at 6 percent for two years converts roughly $112,000 of principal. Plan your cap table for that bump.

What Happens If the Note Hits Maturity with No Round?

This is the maturity cliff, and founders underestimate it. If you reach the maturity date without a qualified financing, the loan is due. You generally have three options, and none are painless.

• Extend - ask holders to amend and push the maturity out. Common, but it signals weakness and costs goodwill.
• Repay - hand back the principal plus accrued interest in cash. Rare for cash-starved startups, which is the whole point of the note.
• Convert at the cap - many notes let the company or holders force conversion into equity at the cap (or a default price) at maturity, avoiding repayment.

The default outcome if you do nothing and cannot repay is a defaulted debt instrument - investors can technically demand payment or pursue remedies. Draft your notes so the maturity converts at the cap, not accelerates, to avoid this trap.

What Does a Worked Convertible Note Example Look Like?

Suppose an angel invests $100,000 on a note with a $5 million cap, a 20 percent discount, 6 percent interest, and a 24-month maturity. Eighteen months later you raise a $4 million Series A at a $20 million pre-money valuation, issuing stock at $2.00 per share.

First, the cap price. The cap implies a conversion price of $5M divided by the pre-money fully diluted share count. If there are 10,000,000 shares outstanding before the round, the cap price is $0.50 per share. The discount price is 80 percent of $2.00, or $1.60 per share.

The cap wins - $0.50 is cheaper than $1.60. The note has accrued roughly $9,400 of interest, so $109,400 converts at $0.50, yielding about 218,800 shares. The new Series A investor at $2.00 gets 2,000,000 shares for $4 million. The angel paid one-quarter the price per share for backing you early.

What Is the Dilution Surprise with Stacked Notes?

Founders often raise multiple notes over time - a friends-and-family note, then an angel note, then a seed extension. Each carries its own cap and discount. Stacked together, they convert at your Series A and can take a far larger slice than you modeled.

Here is the trap. If your earliest note has a $4 million cap and a later note has an $8 million cap, the early note converts cheaply while the later note converts at double the price. The early holders get a windfall, and your own ownership compresses more than expected.

Model every note you issue as if it converts at its best price, then sum them. The aggregate is almost always higher than a single "average" assumption suggests.

Convertible Note vs SAFE vs Priced Seed: Which Should I Use?

This is the question every founder actually faces. The short version: notes are debt, SAFEs are not, and priced rounds are equity from day one. Each fits a different situation. For a full SAFE breakdown, see our SAFE note guide for founders.

The SAFE has become the default for many US seed raises because it removes the maturity and repayment cliff. But notes remain common, especially where investors want the discipline of a maturity date or where local law treats SAFEs awkwardly.

When Does a Convertible Note Still Beat a SAFE?

Despite the SAFE's popularity, notes win in specific situations. If your investor base is traditional angels or family offices who want a maturity date as a backstop, a note feels safer to them than an instrument with no repayment path.

In some non-US jurisdictions, SAFEs map poorly onto local company law, while a loan that converts is well understood. Notes also suit bridge financings where you expect a near-term priced round and want interest to compensate the lender for the short hold.

If you already have stacked SAFEs and want to issue one more instrument with a hard cap and maturity discipline, a note can cleanly slot in. And when modeling your cap table, notes' explicit interest and maturity make the conversion math easier to pin down than a SAFE's sometimes vaguer post-money terms.

What Term Ranges Are Typical for Convertible Notes?

The numbers below are common market ranges for US seed-stage notes, hedged as practice rather than law. Your specifics will vary by investor and momentum.

Watch the interaction: a low cap combined with a high discount and a long maturity compounds the early investor's advantage. Negotiate the cap first, the discount second, and accept standard interest and maturity.

How Should I Think About Notes When Showing Traction?

Investors underwriting your next round will scrutinize your outstanding notes as part of diligence. A pile of stacked notes with aggressive caps is a red flag that signals you gave away equity cheaply and may face a messy conversion.

Keep a clean ledger of every note, its cap, discount, interest, and maturity. When you show traction to investors, pair your growth metrics with a tidy, defensible cap table so the conversion math does not surprise your lead.

Proactively model the fully converted cap table at two or three Series A prices before you start raising. Walking into a lead investor's meeting with that model already built signals operator discipline and prevents last-minute renegotiation.

Frequently Asked Questions

Is a Convertible Note Debt or Equity?

A convertible note is debt on day one - a literal loan documented by a promissory note that accrues interest and carries a maturity date. It is designed to convert into equity at a future priced round, but until that conversion it is a liability on your balance sheet. This debt character distinguishes it from a SAFE, which is neither debt nor equity and has no maturity or repayment obligation.

Do I Have to Repay a Convertible Note If I Never Raise a Round?

If you hit maturity with no qualified financing, the note is technically due and payable in cash, principal plus accrued interest. In practice most founders negotiate an extension or a forced conversion at the cap rather than repaying, because a cash-starved startup rarely has the funds. Draft your notes so maturity triggers conversion at the cap instead of acceleration, avoiding a default that investors could enforce.

Which Is Better for a Founder, a Cap or a Discount?

Neither is "better" in isolation because the investor gets the more favorable of the two at conversion. For the founder, a discount is usually cheaper than a low cap in a high-valuation round, while a cap sets a known ceiling on dilution. Push for a higher cap and a moderate discount; the cap is the term that most directly controls how much ownership you give early investors if your company does well.

How Much Equity Will My Notes Take After a Series A?

It depends on your cap, discount, interest, and how many notes you stacked. As a rough rule, a single seed note with a $6 million cap in a $20 million pre-money Series A converts at roughly a quarter of the round price, taking low double-digit percentage points. Stacked notes with lower caps can take 20 percent or more of the company combined. Model every note at its best conversion price and sum them before you raise.

Are Convertible Notes Still Used If Safes Are More Popular?

Yes. Notes remain common with traditional angels, family offices, and in jurisdictions where SAFEs fit local law poorly. They also suit bridge financings and situations where investors want a maturity backstop. While SAFEs are the US seed default post-2013, notes have not disappeared, and many founders still choose them deliberately for the discipline of explicit interest and a defined maturity.

Key Takeaways

• A convertible note is debt that converts to equity at a qualified financing - it accrues interest and has a maturity date, unlike a SAFE.
• The four core terms are the valuation cap, discount rate, interest rate, and maturity date; the investor gets the better of the cap or discount at conversion.
• The maturity cliff is real: with no round, you must extend, repay, or convert at the cap - draft notes to convert, not accelerate.
• Stacked notes with low caps create a dilution surprise; model every note at its best price and sum the total before raising.
• Notes still beat SAFEs for traditional investors, bridge rounds, and in jurisdictions where SAFEs map poorly onto local law.
• None of this is legal advice - have counsel review every note and model the fully diluted cap table at multiple round prices.