Convertible Note
A loan that converts into shares at the next priced round instead of being repaid, usually at the lower of a discount to the round price and a price implied by a valuation cap. Unlike a SAFE it is debt: it accrues interest, has a maturity date, and ranks ahead of every share class if the company fails before it converts. The older instrument, still common outside the United States.
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Why Convertible Note matters in interviews
The convertible note is the instrument the SAFE replaced in the United States and the one most of the rest of the world still uses, so it is the reference point for every question about caps, discounts and what happens before a price exists. Interviewers ask about it to see whether a candidate understands that it is debt, and what debt means when the borrower is a company with no revenue.
How it works in practice
The terms. A principal amount, an interest rate of typically 2 to 8%, a maturity date of usually 12 to 24 months, a valuation cap, a discount to the next round’s price of typically 15 to 25%, and a qualified financing threshold, the round size that triggers conversion. At a qualified financing the principal plus accrued interest converts into the round’s preferred stock at the lower of the discounted round price and the price the cap implies.
Worked. A $500,000 note at 6% outstanding for a year carries $530,000 into the round. The round prices at $1.50 a share; with a 20% discount the note pays $1.20 and receives 441,667 shares. If a $5m cap implies a price of $1.00 instead, the cap wins and the note receives 530,000 shares. The extra 88,333 shares are the reward for having lent at the point of highest risk.
At maturity without a round. The note is due. In practice the holder extends it, converts it at the cap, or, rarely, calls it, which usually means the company is over anyway. This is the one place a note and a SAFE genuinely differ: a SAFE has no maturity and simply waits.
At a sale before conversion. Debt is paid before every share class, so the holder receives principal and interest ahead of the founders and the preferred, or, if the note allows, converts at the cap and takes the fraction instead. The exit waterfall at /labs/equity-instruments carries the note as its own line for exactly this comparison.
What candidates get wrong
- Ignoring the interest. It converts too, and on a two-year note at 8% it adds 16% to the share count the note receives.
- Applying both the discount and the cap. The note converts at whichever price is lower, never at a discount to the cap price.
- Treating it as safe for the founders. A note that reaches maturity gives the holder leverage a SAFE holder never has, and a stack of notes maturing before a round can force one at a bad time.
- Forgetting it is senior. If the company is wound up, notes are paid before the SAFEs and the preferred, which matters to everyone who is not the note holder.
Convertible Note: frequently asked questions
How does a convertible note convert?
At the next qualified financing round the principal plus accrued interest converts into the round’s preferred shares at the lower of two prices: the round’s price per share less the note’s discount, and the price implied by the note’s valuation cap. The holder receives the amount converting divided by that price in shares. If no round happens before maturity, the note is repaid, extended or converted at the cap by agreement.
What is the difference between a convertible note and a SAFE?
A convertible note is a loan: it accrues interest, has a maturity date, and ranks as debt ahead of every share class if the company fails. A SAFE is not a loan: no interest, no maturity, no repayment, and at a wind-up it ranks alongside preferred stock rather than ahead of it. Both convert at the next priced round using a cap and or a discount. The SAFE is standard for US pre-seed money; the note remains common for bridge rounds and outside the United States.
Practise it
Take a company from founding through a SAFE and a priced seed round. Set the cap, the pre-money and the option pool, watch the price per share and every holder’s stake move, then check your own arithmetic against the table.
Open Cap Table Builder, free, 15 minWhere Convertible Note comes up
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