What is a convertible note in startup funding?

A convertible note is a short-term debt instrument that converts into equity during a future financing round, typically used in early-stage startup investments.

A convertible note is a popular financing instrument used by early-stage startups to raise capital without immediately determining company valuation. It functions as a loan that automatically converts into equity shares during a subsequent funding round, typically a Series A.

Key features include a discount rate (usually 10-30%) that gives early investors more shares than later investors, and often a valuation cap that sets a maximum company valuation for conversion purposes. The note also carries an interest rate (typically 2-8% annually) and a maturity date (usually 12-24 months).

Convertible notes offer several advantages: they're faster and cheaper to execute than equity rounds, avoid early valuation negotiations, and provide investor protection through conversion terms. For startups, they enable quick capital raising while preserving equity for future rounds.

However, they also carry risks. If the startup fails to raise a qualifying round before maturity, the debt may need to be repaid or renegotiated. Additionally, multiple convertible notes can create complex cap table scenarios.

The conversion mechanics typically trigger during a "qualified financing" - usually defined as raising a minimum amount (e.g., €500K-€2M) in a priced equity round. Understanding these instruments is crucial for startup founders navigating early fundraising.

For personalized guidance, consult a Startup Law specialist like Pierre Van Hoorebeke at Peak Legal on TinRate.