Convertible Notes Are Not Free Money. Here Is What Founders Get Wrong.
A convertible note is a short-term loan that converts to equity at a future financing round. It is the most common pre-seed financing instrument, and it is also one of the most misunderstood. The valuation cap, discount rate, and interest provisions all affect the founder's dilution at conversion, often more than founders expect when they sign.
Author: Yanni Papoutsi · Fractional VP of Finance and Strategy for early-stage startups · Author, *Raise Ready*
Published: 2025-03-08 · Last updated: 2025-03-08
Reading time: \~8 min
What Is a Convertible Note?
A convertible note is a debt instrument that converts into equity at a future financing round rather than being repaid in cash. It is designed to defer the valuation question to a future date when there is more information to price the company accurately. In practice, it is the standard instrument for pre-seed and some seed-stage financing. Key facts at a glance:
The Three Terms That Determine Your Dilution
Valuation cap. This is the maximum valuation at which the note converts to equity, regardless of the actual valuation in the next round. If a note has a $5M cap and the Series A prices at $10M, the note converts as if the valuation were $5M. This means the note holder gets twice as many shares as a Series A investor for the same dollar amount.
A lower cap means more investor-friendly terms. A higher cap means more founder-friendly terms.
Discount rate. The discount gives note holders the right to convert at a reduced price relative to the next round's price. A 20% discount means if the Series A prices shares at $1.00, the note converts at $0.80 per share. The note holder again gets more shares than the Series A investor for the same amount.
Interest. The note accrues interest over time, which typically converts alongside the principal at the next round. On a $500k note at 6% annual interest held for 18 months, roughly $45k of additional principal converts to equity.
Key insight: The cap and discount do not add together. The note converts at whichever mechanism is more favourable to the investor at the time of conversion. If the cap gives the investor a better price than the discount, the cap applies. Model both scenarios.
The Dilution Calculation Most Founders Skip
Here is the calculation founders should run before signing a convertible note:
Scenario: $500k note, $4M cap, 20% discount, 5% interest. Company raises a $3M Series A at $8M pre-money valuation.
At the Series A, shares price at $8M / (shares outstanding). Call that $1.00 per share.
Cap conversion price: $4M cap / Series A share price denominator = effectively $0.50 per share.
Discount conversion price: $1.00 x (1 - 20%) = $0.80 per share. The note converts at $0.50 (the cap applies, as it is lower and more favourable to the investor).
Principal + accrued interest: $500k + \~$37.5k (18 months at 5%) = $537.5k.
Shares issued at conversion: $537.5k / $0.50 = 1,075,000 shares. A Series A investor putting in $537.5k at $1.00 per share gets 537,500 shares.
The note holder gets twice as many shares for the same dollar amount. This is not a bad outcome. Early investors deserve better economics for taking early risk. But it is the calculation founders should do before agreeing to a cap, not after.
Common Convertible Note Mistakes
Setting the cap without modelling the dilution. The cap feels
like a number you negotiate. It is actually a dilution commitment. Know what it means before agreeing to it.
Ignoring the maturity date. Most convertible notes have a
maturity date of 12-24 months. If the qualifying financing round has not happened by then, the note is technically due for repayment. Most note holders will extend or convert anyway, but the maturity creates leverage that can be used against founders who are running out of time.
Forgetting about interest. On a $1M note at 6% interest over 18
months, the accrued interest at conversion is $90k. That is additional dilution that founders often do not model.
Not defining "qualifying financing." The conversion trigger
needs a clear definition of what counts as a qualifying round. Ambiguity here creates renegotiation risk later.
Treating all notes as equivalent. A note with a $3M cap and no
discount is very different from a note with a $6M cap and a 25% discount. Model both before comparing investor proposals.
SAFEs vs. Convertible Notes: What Is the Difference?
A SAFE (Simple Agreement for Future Equity) is a non-debt instrument that converts similarly to a convertible note but without interest or a maturity date. YCombinator popularised the SAFE as a founder-friendly alternative.
In markets where SAFEs are well understood (US, increasingly UK), they are generally preferable from a founder perspective. In markets where they are less common, note holders may prefer the debt structure as more familiar.
Frequently Asked Questions
Can a convertible note convert at IPO?
Typically yes, though the conversion mechanics vary. Most notes convert automatically at a qualifying financing round, with IPO often defined as a separate conversion event. Read the note terms for the specific trigger definition.
What happens if the company raises a down round?
If the Series A prices lower than the note's cap, the cap does not apply and the note converts at the round price (or the discounted price if the discount is more favourable). This is rare but models the scenario where early optimism was not validated.
Should I use a single note or multiple notes for a pre-seed round?
Most pre-seed rounds use multiple notes from multiple investors, all converting on the same terms. A note purchase agreement with a defined aggregate cap ensures consistency. Individual notes with different terms create a complex conversion calculation at Series A.
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