Convertible notes

Your first angel puts $500,000 into your company on a “convertible note”. After 18 months, at your Series A, the angel gets 552,500 shares, not 500,000. The 52,500 more shares come from interest on a loan that you never pay in cash. This lesson shows what a note is, how it converts, and where it can cost you.

A loan that becomes shares

A convertible note is a loan from an investor to a startup. The investor does not want the money back. The plan is that the loan converts into shares at the next priced round, when the company sells shares at a fixed price.

Here is an example. An angel lends Northwind Labs $500,000 on a note. After 18 months, Northwind raises a Series A. The $500,000 and its interest convert into Series A shares, and Northwind pays no cash to the angel.

A note does the same job as a SAFE. The two let a startup raise money before anyone sets a price per share. But a note is a loan. Thus it has two items that a SAFE does not have: interest and a maturity date.

The terms of a note

A note has five terms that change what the investor gets:

• Principal: the sum of the loan, for example $500,000.
• Interest rate: the percentage that the loan increases by each year.
• Maturity date: the date when the loan is due if it did not convert.
• Valuation cap: the highest company value at which the note converts.
• Discount: a percentage off the price that the new investors pay.

Principal and interest

The principal is the money that the investor lends. Interest is the sum that the loan increases by each year. Startups almost never pay note interest in cash. The company adds the interest to the principal, and the interest converts into more shares.

Most notes use simple interest, which the note calculates on the principal only:

Interest = Principal × Rate × Years
         = $500,000 × 7% × 1.5
         = $52,500

Thus $552,500 converts, not $500,000. The investor gets 10.5% more shares than the principal alone buys.

Maturity date

The maturity date is the date when the loan becomes due if it did not convert. In the 2025 Canadian deals of the law firm Osler, the median term was 24 months and the average was 26.2 months. The last part of this lesson shows what can occur on that date.

Valuation cap

The valuation cap is the highest company value at which the note converts. It is a reward for the risk of the first investors. If the Series A values the company at more than the cap, the note converts as if the value were the cap.

The cap gives a price per share, the cap price:

Cap price = Valuation cap
            ÷ Shares before the round
          = $8,000,000 ÷ 8,000,000
          = $1.00

Most notes use a pre-money cap. The share count is the fully diluted shares before the round, without the shares from notes and SAFEs. A post-money SAFE uses a different count, and the last section of this lesson compares the two.

Discount

The discount lets the noteholder pay less than the new investors. Cooley gives 15% to 25% as the usual range. In Osler’s 2025 Canadian data, the median discount for notes and SAFEs was 20%. The discount gives the discount price:

Discount price
  = Series A price × (1 − Discount)
  = $2.00 × (1 − 20%)
  = $1.60

The lower price applies

A note with a cap and a discount does not add the two together. The noteholder gets the lower of the two prices. Cooley says that the two terms apply “in the alternative”.

With a $1.00 cap price and a $1.60 discount price, the noteholder pays $1.00. If the Series A price is only $1.10, the discount price is $0.88, and the discount applies. The discount gives the lower price only when the round price is less than cap price ÷ (1 − discount). Here that limit is $1.00 ÷ 0.8 = $1.25.

Qualified financing

A note converts automatically only in a priced round of a minimum size, a qualified financing. Cooley says that the minimum is “typically something like one to two times the principal amount of notes outstanding”. This rule stops a conversion in a very small round that the company controls.

For example, a $500,000 note has a $1,000,000 minimum. A $600,000 priced round does not convert the note automatically. In the Cooley model note, the holders can then select conversion.

How a note converts

Predict first

Northwind's note has a 20% discount. The Series A investors pay $2.00 a share, and the note's cap price is $1.00. As a percentage, how much less than the Series A investors does the noteholder pay?

Type a guess before you continue. A guess first, even a wrong one, makes the answer easier to remember.

Your guessSave my guess

Worked example · step 1 of 6

Northwind's note converts at the Series A

1. 1

   The facts

   The note is $500,000 at 7% simple interest, with an $8M pre-money cap and a 20% discount. It converts 18 months after Northwind signed it. Northwind has 8,000,000 fully diluted shares before the round, without the note. The Series A price is $2.00.

Show step 2Show all steps

In the simulator, the Series A price comes from the Series A pre-money valuation ÷ the pre-money shares. Those shares include the note’s own shares, so the price moves a little when the note increases. Move the months first. Then decrease the Series A pre-money until the discount applies.

Simulator

The note clock

Move the months to the Series A. Watch the interest increase the balance, and the balance convert into more shares.

Months from the note to the Series A

18 months

The note

Principal

Interest rate, each year

7%

Valuation cap (pre-money)

$8M

Discount

20%

Maturity date

24 months

Interest

SimpleCompound, yearly

The Series A

Pre-money valuation

$16M

New money

Note balance

$552.5K

$500K + $52.5K interest

Conversion price

$1.00

Cap price. Series A pays $1.8708.

Shares for the note

552,500

52,500 from interest

Noteholder owns

5.17%

after the Series A

• Balance with interest
• Principal only

Ownership after the Series A

• Founders
• Noteholder
• Series A investors

After 18 months, the $500K note has a balance of $552.5K. At the Series A it converts into 552,500 shares, 52,500 more than the principal alone buys.

The cap price ($1.00) is lower than the discount price ($1.4966), so the cap applies. The noteholder pays 47% less than the Series A investors.

Work it out

Same note, same 18 months, but the Series A price is $1.10. How many shares does the note get? Round down to a whole share.

Your answerCheck

Work it out

A $250,000 note has 6% simple interest and converts after 24 months. The cap price is $0.50, and the discount price is $0.72. How many shares does the note get?

Your answerCheck

Simple or compound interest

Some notes compound the interest once a year. Then the note also calculates interest on the interest of the previous years:

Compound balance
  = Principal × (1 + Rate)^Years
  = $500,000 × 1.07^1.5
  = $553,408

That is only $908 more than simple interest. The rate and the time are much more important than the method. Try the “Compound, yearly” switch in the simulator.

What can occur at the maturity date

Now it is month 24, and no priced round occurred. The $500,000 note at 7% owes $570,000:

Balance = $500,000
          + ($500,000 × 7% × 2)
        = $570,000

Many startups do not have $570,000 of cash to use for this. The words in the note set the result. Cooley and its model note give four usual results:

1. Repayment. The money becomes due. In the Cooley model note, it is due “upon request of the Majority Holders on or after” the maturity date. Nothing occurs until the holders of a majority of the principal tell the company to pay.
2. Conversion at a set price. Many notes let the holders convert at maturity, or make them convert, frequently at the cap. Some notes convert into common stock, and some into a new series of preferred stock.
3. Extension. The company and the holders sign an amendment with a new maturity date. In exchange, the holders sometimes get better terms.
4. No action. The holders do not tell the company to pay, and the interest continues.

The risk for the founder is a loss of control. On the maturity date, the holders can tell the company to pay cash that it does not have. Y Combinator says that a note’s maturity date “can force repayment or default”.

Scenario

Maturity day

Northwind's $500K note is due today, at month 24. No priced round came. Set the cash in the bank and select what occurs.

Cash in the bank

$300K

What occurs

RepayConvertExtendWait

Due today

$570K

$500K + $70K interest

Cash after

$300K

Less than the $570K due

Debt left

$570K

Noteholder owns

0%

Ownership after this choice

The company has $300K and owes $570K. If the holders of a majority of the principal tell the company to pay, it cannot, and it is in default. Then the holders set the terms of the talks that follow.

With less cash than the debt, the founders negotiate from a weak position. Agree on extension and conversion terms when you sign the note, not on maturity day.

Why SAFEs replaced most notes

Y Combinator made the SAFE in late 2013 as “a replacement for convertible notes”. A SAFE converts like a note, but it is not a loan. It has no interest and no maturity date, and it is one short standard document. Usually the cap is the only term to negotiate.

Notes stay frequent in four areas:

• Canada. In Osler’s 2025 Canadian deals, notes were 48.2% of the convertible deals by count and 68.3% by dollars.
• Bridges between priced rounds. Y Combinator gives bridge loans for later-stage companies as one use for notes. Osler also found notes more frequently in later-stage bridge rounds.
• Some industries. In Osler’s 2025 data, notes were 82.4% of the cleantech convertible deals.
• Investors who want to be lenders. A noteholder is a creditor. If the company closes, it pays its creditors before its shareholders.

A note cap is not a SAFE cap

The two caps look the same, but they measure different things. A post-money SAFE cap includes the SAFE money, so the investor owns investment ÷ cap. A note usually has a pre-money cap. Thus at the cap, the note operates like a priced round at that pre-money valuation.

Compare $1M at a $10M cap, converted at the cap, before the new money of the round:

Instrument	The investor owns
Post-money SAFE	$1M ÷ $10M = 10%
Note with a pre-money cap, no interest	$1M ÷ ($10M + $1M) = 9.09%
The same note after 18 months at 7%	$1.105M ÷ ($10M + $1.105M) = 9.95%

The share count in the note is important too. The Cooley model note divides the cap by the fully diluted shares before the financing, without notes and SAFEs. Optional text in brackets can add the option pool and the pool top-up of the new round. A larger count gives a lower cap price and more shares for the noteholder. Thus founders want to keep the pool top-up out of this definition.

The last lesson of this module compares all three instruments: SAFE, note, or priced round.

Quiz · question 1 of 5

Test what you learned

A $500,000 note has 8% simple interest and converts after 12 months. The cap price is $1.00 and the discount price is $1.20. How many shares does the holder get?

• A450,000
• B500,000
• C416,667
• D540,000