What Is a Convertible Note? Terms, Math and Limits

James Firth · November 2, 2026 · AI Funding Analysis

Summary

A convertible note is short-term debt that converts into equity at a startup's next priced round, usually at a discount or under a valuation cap. It carries interest and a maturity date, unlike a SAFE. This guide explains in plain terms what a convertible note contains, works through a full conversion with real numbers, and shows when founders should still choose one.

Signed startup financing agreement on a walnut desk with a pen and laptop

What is a convertible note? It is a short-term loan that a startup repays in equity instead of cash, usually at its next priced round. The investor wires money today, the company books it as debt, and the debt converts into shares at a discount or under a valuation cap once a qualifying financing closes. That is the whole instrument. Everything else is terms.

The terms are where the money moves. A 20% discount, an $8M cap and 6% interest on a $500K note produce a materially different cap table than the same note without the cap. This guide walks through the mechanics with one worked example, then flags where notes still beat the alternatives.

What does a convertible note actually contain?

Five terms define almost every note. Read them in this order, because the first two decide who holds the leverage.

Principal: the amount wired. Pre-seed notes in AI companies commonly sit between $100K and $1M per investor.
Maturity date: when the debt comes due if no priced round has happened. Twelve to 24 months is the usual window, and 18 months is the median you will see in term sheets.
Interest rate: typically 2% to 8% a year, simple rather than compounding. It accrues on the principal and converts into shares along with it, so it works as a quiet extra discount.
Discount: the percentage off the next round's price per share. Ten to 25% is the common band, and 20% is the default anchor.
Valuation cap: the ceiling on the valuation used to convert the note. It protects the investor if the company reprices upward fast.

The note also defines a qualified financing, the minimum raise (often $1M or more of new equity) that triggers automatic conversion. Below that threshold the note may stay outstanding or convert only if the investor agrees. That clause is routinely skimmed and routinely disputed.

Founders and an investor reviewing paperwork at a conference table

How does conversion work in a real round?

Take a $500K note at 6% simple interest, a 20% discount and an $8M cap. The company closes a Series A 18 months later at a $12M pre-money valuation, with 10,000,000 fully diluted shares before the round.

First, the amount converting. Interest of $500K x 6% x 1.5 years adds $45K, so $545K converts, not $500K.

Next, three candidate prices per share:

Series A price: $12M / 10M shares = $1.20.
Discount price: $1.20 x 0.80 = $0.96.
Cap price: $8M / 10M shares = $0.80.

The note converts at the lowest of those, which here is the cap price. $545K / $0.80 gives 681,250 shares. At the full Series A price the same money would have bought about 454,167 shares. The noteholder receives roughly 50% more stock for the same dollars, an effective 33% discount to the round price.

The delta compounds the other way for founders. Those extra shares come out of the pre-money, so the founders absorb them. Run this math before signing, not after the Series A term sheet lands. A cap that looked generous at $8M on a pre-product company reads very differently when the company is raising at $12M.

Why do notes carry interest and a maturity date at all?

Because a note is debt, and debt has a clock. Interest compensates the investor for waiting. Maturity gives the investor a lever: on the due date they can demand repayment, extend the note, or negotiate a conversion at a fixed valuation.

In practice almost nobody demands repayment from a pre-revenue startup, because the money is spent and the demand would wipe out the company and the investor's chance of upside. What the maturity date does buy is a negotiating position. A founder staring at a maturity date in four months has less room to say no to an extension that comes with a lower cap or a board seat.

This is the point most explainers soften. The maturity date is not paperwork. It is the single term that distinguishes a note from a SAFE, and it is the one that shifts power toward the investor when fundraising runs late.

Whiteboard timeline sketch showing stages of a funding round

Convertible note vs SAFE: where do the two split?

A SAFE (simple agreement for future equity) is not debt. It has no interest, no maturity date and no repayment obligation. Y Combinator introduced it in 2013 to remove the legal friction of notes, and that simplicity explains the market share. Carta reported that SAFEs made up 90% of pre-seed rounds on its platform in Q1 2025, with convertible notes at the remaining 10%.

For a deeper legal comparison, the Haynes Boone overview of SAFEs and convertible notes lays out the instrument differences clause by clause.

The practical split comes down to four items:

Cost to close: a SAFE uses a standard template, so legal spend is minimal. A note usually needs a lawyer to tailor interest, maturity and conversion mechanics.
Founder risk: a SAFE has no cliff. A note has a maturity date that can force a hard conversation.
Investor protection: a note ranks as debt, which gives the investor a creditor claim in a wind-down. A SAFE holder ranks alongside preferred equity at best.
Tax and accounting: interest on a note accrues and can create tax reporting. A SAFE does not.

Skip the note if your lead is a standard US seed fund that will happily sign a post-money SAFE. You are paying legal fees for terms nobody needs. The note earns its place in the cases below.

When does a convertible note still make sense?

Three situations keep notes alive despite the SAFE's dominance.

Non-US investors and institutions. Angels in some jurisdictions, and corporate or bank-affiliated investors, are legally or culturally more comfortable with a debt instrument. A SAFE is a US construct, and some counsel will not opine on it.

Bridge rounds between priced rounds. When a company with existing preferred stock needs six months of runway, a bridge note with a short maturity is a clean way to extend without repricing the company. Existing investors often prefer the debt seniority.

Structured investor demands. If a lead insists on interest or a hard maturity as the price of writing the check, a note is the instrument that carries those terms.

Brass balance scale beside a stack of coins on a stone surface

Which numbers should a founder model before signing?

The cap table effect is the thing to quantify, so build the model before the negotiation, not during it. Four checks cover most of the risk.

Stacked notes: if you raise three notes at three different caps, each converts at its own price. Model the total new shares, not each note alone.
Dilution at your expected Series A valuation: run the conversion at a low case, a base case and a high case. The cap matters most in the high case.
Interest drag: at 8% simple interest over 24 months, a note converts at 116% of principal. That is a 16% extra discount hidden in the arithmetic.
Post-money versus pre-money cap definitions: the same headline cap number gives the investor a different ownership percentage depending on whether other notes are counted in the cap.

Tooling helps here. Cap table platforms such as Carta model conversion scenarios directly, and the funding databases covered across this site, including PitchBook, give you comparable round data to set a defensible cap.

What paperwork and signing tools does a note require?

A note is a contract, so the closing checklist is longer than for a SAFE. Expect a note purchase agreement or a standalone note, a board consent authorizing the issuance, a securities exemption filing where applicable (Form D in the US for Rule 506 offerings), and an updated cap table.

Most early-stage companies close these electronically. Document and e-signature tooling is a commodity, so pick on price and audit trail rather than features. Two options worth pricing for a small closing:

Keep a signed PDF of every note in the same folder as your cap table export. At the Series A, diligence counsel will ask for both within the first week, and a missing signature page can delay the close by days.

Which mistakes show up most often in note rounds?

Three errors recur in the closing documents we see described by founders and counsel.

Ignoring the stack: founders compare each note to the Series A in isolation, then discover that four small notes at four different caps convert into a much larger block than any single one suggested.
Missing a maturity extension clause: without a pre-agreed extension mechanism, an 18-month note on a 20-month fundraise creates an awkward renegotiation at the worst moment.
Vague qualified financing definition: if the trigger amount is low, a small insider round can force conversion at the cap before the company has priced anything meaningful.

Each one is cheap to fix at signing and expensive to fix later. A one-page conversion model, shared with the investor before the note is signed, removes most of the disagreement.

What would we actually do?

Use a post-money SAFE if you are raising from US seed funds and your counsel agrees. Use a convertible note when an investor requires interest, when you need a short bridge, or when a non-US investor cannot hold a SAFE. In every case, model conversion at three Series A valuations before you accept a cap, because the cap is the term that decides how much of the company you still own.

The signal to retain: a note is debt that becomes equity, and the cap and the maturity date are the two terms that decide who holds leverage. Everything else is rounding.

Frequently asked questions

What is a convertible note in simple terms?

A convertible note is a loan to a startup that is repaid in shares instead of cash. It converts into equity when the company closes a qualifying priced round, typically at a discount to the round price or under a valuation cap.

How does interest work on a convertible note?

Interest accrues on the principal, usually 2% to 8% a year as simple interest. It does not get paid in cash. The accrued amount converts into shares together with the principal, which acts as an extra discount for the investor.

What happens if a convertible note reaches its maturity date?

The company technically owes repayment. In practice the parties usually extend the note, renegotiate the cap or discount, or convert it at an agreed valuation. Founders with little cash have limited leverage at that point.

What is the difference between a discount and a valuation cap?

The discount reduces the conversion price by a percentage of the next round's price. The cap sets a maximum valuation for conversion. When a note has both, the investor converts at whichever price is lower.

Is a convertible note better than a SAFE?

For most US seed rounds a SAFE is simpler and cheaper, and Carta data shows it dominates pre-seed deals. A convertible note fits when the investor needs interest or a maturity date, or cannot hold a SAFE.

Do convertible notes count as debt on the balance sheet?

Yes. Until conversion, a note is recorded as a liability, and accrued interest is tracked as well. This is one reason accountants and investors treat notes differently from SAFEs during diligence.