Convertible Notes: Debt Now, Equity Later

Welcome to 'Understanding Term Sheets', a four-part guide designed for startup founders, early executives, and angel investors. Term sheets are the blueprints of startup financings. They set valuation, economic terms, and governance. Each post in this series stands alone, but together they form a practical playbook for navigating SAFE notes, convertible notes, priced equity rounds, and secondary sales.

In this series, we cover:

  • SAFE Notes – The fast, simple agreement for early-stage funding

  • Convertible Notes – Debt that turns into equity later

  • Priced Equity Rounds – Locking in valuation and ownership

  • Secondary Sales – Selling existing shares for liquidity

Short definition: A convertible note is a short-term loan that converts into equity upon a triggering financing event. It bridges the gap between seed capital and a priced round while allowing investors to capture upside through valuation caps or discounts.

Why Founders & Investors Use Convertible Notes

  • They were the pre-SAFE standard because they combined speed with investor protections

  • They let startups raise quickly while setting conversion mechanics (cap, discount) that reward early risk

Key Components in a Convertible Note Term Sheet

  • Principal and interest rate — the loan amount and annual interest (usually modest)

  • Maturity date — when the note must convert or be repaid (important to watch)

  • Valuation cap — sets the maximum valuation for conversion

  • Discount rate — incentivizes early investors by offering a lower conversion price

  • Conversion triggers — typically a qualified financing or liquidation event

Advantages for Startups

  • Faster and cheaper than a priced equity round

  • Allows deferring valuation until the company is larger and easier to price

  • Interest accrues and converts into equity, aligning incentives

Risks and Pitfalls

  • Maturity risk — if the company cannot raise or convert by maturity, the note technically becomes repayable

  • Accrued interest increases dilution when it converts to equity

  • Cumulative notes with varying caps and terms create complex cap tables

Convertible Note vs. SAFE — Quick Comparison

  • Convertible notes are debt instruments (have interest and maturity); SAFEs are not.

  • Notes can create repayment risk if a follow-on round is delayed.

  • SAFEs are usually simpler; notes give slightly more formal investor protections.

Negotiation Tips for Founders

  • Keep the maturity reasonable; negotiate extensions if needed

  • Limit the interest rate so conversion math is predictable

  • Be cautious about adding creditor-style protections that could complicate later rounds

Bottom Line

Convertible notes are a solid bridge instrument when you expect a priced round soon. Model conversion scenarios and keep the maturity and interest terms founder-friendly.

✅ Next up: Priced Equity Rounds – Locking in Your Valuation to understand what comes after SAFEs and notes.