Convertible Note

A short-term startup loan that converts into equity at a future funding round rather than being repaid in cash — the most common financing instrument for early-stage startups before a priced equity round.

A convertible note is a form of debt — a loan — that is designed to convert into equity at a future financing event rather than be repaid in cash. An investor lends a startup $500,000 via a convertible note, and when the startup raises its Series A (or another priced round), that $500,000 automatically converts into shares at a price determined by the note's terms — typically at a discount to what Series A investors pay. Convertible notes allow early-stage startups to raise money quickly without having to negotiate a full company valuation, which is difficult when the company is too young to price reliably.

For startup employees, convertible notes matter because they affect the cap table — and therefore the value of employee equity. When a convertible note converts into equity, new shares are issued to the noteholder. This dilutes existing shareholders, including employees with vested options. The key terms that determine how much dilution occurs and at what price notes convert are: the discount rate (typically 15–20%, meaning note investors get shares at 80–85% of the Series A price), the valuation cap (a ceiling on the price at which the note converts, protecting early investors if the Series A values the company very highly), and the interest rate (typically 4–8% annually, which accrues and also converts to equity).

The valuation cap is the most employee-relevant term. If a note has a $5M cap and the Series A prices at $20M pre-money, the noteholders convert at the $5M cap price — getting 4x as many shares as Series A investors per dollar invested. Those extra shares come from existing equity holders, including founders and employees. A large note overhang (substantial convertible notes outstanding relative to company value) can mean significant dilution for employees when it converts. Before joining an early-stage startup, employees should ask how much convertible note financing is outstanding and what the caps are.

Convertible notes have largely been displaced by SAFEs (Simple Agreements for Future Equity) at the earliest stages — SAFEs are simpler, have no interest rate, no maturity date, and no debt mechanics. However, convertible notes remain common for startups that want debt treatment on their balance sheet, for investors who require the legal protections of debt, or for bridge financing between priced rounds. If you join a startup that has raised 'bridge financing' or a 'bridge round,' you are almost certainly looking at convertible notes.

Key Convertible Note Terms

  • Principal: the amount loaned. This plus accrued interest converts to equity at the next round.
  • Discount rate: the percentage discount note investors receive on the next round's price. A 20% discount means if Series A prices at $1.00/share, noteholders convert at $0.80/share — getting more shares per dollar.
  • Valuation cap: the maximum price at which the note converts. If the cap is $6M and Series A is at $20M pre-money, noteholders convert as if the price were $6M — getting more shares than at the Series A price. The cap protects early investors who took more risk.
  • Interest rate: typically 4–8% annually, simple interest. Accrues over the note's term and converts to additional shares along with the principal.
  • Maturity date: when the note is technically due for repayment if no qualifying financing has occurred. In practice, startups rarely repay; either a round happens, the note is extended, or the company fails.
  • Most-favored-nation (MFN): if the company issues subsequent notes with better terms, MFN provisions automatically update existing noteholders to those better terms.

How Convertible Notes Affect Employee Equity

  • When notes convert, new shares are issued — diluting all existing shareholders including employees with vested options.
  • Large note amounts relative to company size create significant dilution events at conversion — especially if valuation caps are low compared to the Series A price.
  • Employees should ask: how much in convertible notes is outstanding? What are the caps? How much dilution will the cap table absorb when they convert?
  • Bridge round dilution is often underestimated: a startup that raises a $2M convertible bridge at a $4M cap before a $15M Series A will see those bridge notes convert at the cap price, creating substantial dilution before employees' options gain value.
  • If a startup fails before a qualifying round, convertible noteholders are creditors — they have a legal claim on company assets that ranks ahead of equity holders (including employees with options or vested shares).

Example

A startup raises $1M in convertible notes with a $6M valuation cap, 20% discount, and 6% interest rate. Eighteen months later it closes a Series A at a $15M pre-money valuation ($1.50/share). The note principal plus interest ($1,060,000) converts at the lower of (a) the cap price: $6M / (shares outstanding) — giving a per-share price well below $1.50 — or (b) the discounted price: $1.50 × 80% = $1.20. The cap price is lower, so noteholders convert at the cap price and receive approximately $1M / cap price per share in shares. An early employee who joined before the bridge and holds 100,000 vested options sees her ownership percentage fall as both the bridge conversion and Series A shares are issued. She should track this dilution in her equity model — the absolute value of her stake may still increase (if valuation rose enough), but her percentage ownership has shrunk.