What Is a Convertible Note?
A convertible note is a short-term debt instrument that converts to equity at a future funding round. Widely used for early-stage bridge funding.
Key Takeaways
- A convertible note is debt that converts to equity at the next priced round
- Key terms: interest rate, maturity date, discount rate, and valuation cap
- A SAFE (Simple Agreement for Future Equity) is a simpler alternative without the debt structure
- Convertible notes defer valuation — useful when it is too early to set a defensible price
What a convertible note is
A convertible note is a short-term debt instrument — technically a loan — that is designed to convert into equity at a future priced funding round rather than being repaid in cash. It allows a company to raise money quickly, without the cost and complexity of a full priced equity round, and defers the difficult question of valuation to a future round when there is more data to support a credible price. Convertible notes are most commonly used for bridge rounds between priced rounds, or for very early stage fundraising before a company has enough traction to set a fair valuation.
The key terms
Interest rate: convertible notes accrue interest (typically 5-8% per year), which converts to equity along with the principal at the next round. Maturity date: the date on which the note must either convert or be repaid — typically 12-24 months. If no qualifying funding round occurs before maturity, the note technically comes due as debt. Discount rate: the percentage discount to the next round price at which the note converts — rewarding early investors for their risk. A 20% discount means note holders convert at 80p for every £1 the new investors pay. Valuation cap: a ceiling on the price at which the note will convert, regardless of how high the next round valuation is.
The SAFE instrument
The Simple Agreement for Future Equity (SAFE) was developed by Y Combinator as a simpler alternative to convertible notes. A SAFE is not debt — it has no interest, no maturity date, and no risk of being called as a loan. It converts to equity at the next priced round on the same terms as a convertible note (discount and/or cap). SAFEs have become the dominant pre-seed instrument in the US startup ecosystem and are increasingly common in the UK, though many UK lawyers still prefer convertible loan notes due to their legal familiarity.
Valuation cap dynamics
The valuation cap is the most commercially significant term in a convertible note or SAFE. If a company raises a note with a £3 million cap and then raises a priced round at an £8 million valuation, the note holder converts at the £3 million cap — meaning they get 2.67x more shares than the new investors per pound invested. If the priced round comes in at £2 million (below the cap), the cap is irrelevant and the holder just gets the discount. The cap should be set to reflect the expected valuation at the next round — caps set too low create misalignment with new investors.
When to use convertible notes
Convertible notes make sense when: you need capital quickly and cannot spend 3-4 months on a full priced round process; it is too early to defend a credible valuation with traction data; you are bridging between rounds and expect a priced round within 12 months; or your lead investor prefers a note structure. Avoid stacking too many convertible notes before a priced round — a complex note stack with multiple caps and discounts creates messy cap table dynamics and can complicate the eventual priced round.