Raising early-stage capital is one of the biggest challenges for startup founders. Traditional equity financing can be expensive and time-consuming, while investors want structures that are legally simple but still give them upside potential. One solution that has gained popularity over the past decade is the convertible note .

At Angel School, we often get asked: What is a convertible note, how does it work, and when should I use it instead of equity or a SAFE agreement? This guide breaks it all down for founders and angel investors, so you can confidently navigate startup financing.

What is a Convertible Note?

A convertible note is a short-term debt instrument that converts into equity in a future financing round, usually at a discount or with a valuation cap.

In simpler terms:

• A startup borrows money from an investor.

• Instead of repaying in cash, the loan converts into company shares during the next funding round.

• The investor often gets a discount or a valuation cap as compensation for taking on early risk.

This structure allows startups to raise money quickly without having to set a valuation too early, and it gives investors equity upside when the company grows.

Why Do Startups Use Convertible Notes?

Startups, especially in the pre-seed or seed stage, often lack enough traction to justify a fair valuation. Negotiating equity at this stage can be difficult, expensive, and distracting. A convertible note solves this problem by:

1. Delaying Valuation Discussions
   Founders don’t have to agree on a specific valuation immediately. Instead, valuation is determined later, usually when a professional venture round happens.

2. Speed and Simplicity
   Convertible notes are faster and cheaper to draft than a priced equity round. This saves on legal fees and allows startups to close funding quickly.

3. Investor Incentives
   Early investors are rewarded for their risk with discounts, valuation caps, or both when the note converts into equity.

Key Terms in a Convertible Note

Before signing, both founders and investors should understand the key terms that govern how and when conversion happens.

1. Principal Amount

This is the money the investor lends to the startup. For example, an investor might invest $100,000 via a convertible note.

2. Interest Rate

Convertible notes often carry interest (commonly 2–8% annually). Instead of being repaid in cash, the accumulated interest also converts into equity.

Example: If $100,000 is invested at 5% interest for one year, the total amount converting to equity becomes $105,000.

3. Maturity Date

The maturity date is the deadline by which the note must either convert into equity or be repaid. Typically, this ranges from 12–36 months.

However, most notes don’t get repaid in cash—they convert when the company raises its next round of financing.

4. Conversion Trigger

This defines when the note converts into equity. Usually, this happens at the next qualified financing round (eg, raising at least $1M from VCs).

5. Discount Rate

A discount rewards early investors by allowing them to buy shares at a lower price than new investors. Discounts typically range from 10–30% .

Example : If the next round values ​​shares at $2.00 each and the discount is 20%, the convertible note holder buys in at $1.60 per share .

6. Valuation Cap

The cap sets the maximum company valuation at which the note converts, regardless of the next round's valuation. This ensures early investors don't get diluted if the startup's value skyrockets.

Example : If the cap is $5M and the company raises at a $10M valuation, the note holder converts as if the company was valued at $5M.

7. Conversion Mechanics

Some notes allow automatic conversion, while others require investor consent. This impacts how flexible the deal is for both parties.

Convertible Note Example

Let's look at a simple scenario:

• Investor: Jane invests $100,000 via a convertible note.

• Terms: 5% interest, 20% discount, $5M valuation cap, 24-month maturity.

• After 12 months, the startup raises $2M at a $10M valuation.

Here's what happens:

• Loan + interest = $105,000.

• With the discount , Jane's conversion price is $8M valuation instead of $10M.

• With the cap , Jane's conversion price is based on $5M valuation (even better).

• Result: Jane gets significantly more equity than new investors at the $10M round.

This illustrates why convertible notes are attractive to early backers.

Advantages of Convertible Notes

For Founders:

• Fast & Low-Cost → Less legal complexity than equity rounds.

• Flexible Valuation → Avoids premature valuation disputes.

• Bridge Financing → Works well as a bridge between rounds.

For Investors:

• Upside Potential → Discount and cap protect against dilution.

• Downside Protection → Technically structured as debt, giving priority in case of liquidation.

• Simple to Execute → Easier than negotiating preferred stock rights early on.

Risks and Challenges of Convertible Notes

Despite their popularity, convertible notes aren't perfect. Both founders and investors should be aware of the downsides.

Founder Risks

1. Over-Dilution → A low valuation cap can give away too much equity.

2. Debt Pressure → If no financing round occurs by maturity, the debt may technically be payable in cash.

3. Complex Cap Table → Multiple notes with different caps and discounts can complicate ownership structure.

Investor Risks

1. Uncertain Equity → Until conversion, investors don’t know exactly how much equity they will receive.

2. Startup Failure → Notes are still risky—if the company folds, debt repayment is unlikely.

3. Unfavorable Terms → If a note has no cap, investors might end up converting at a very high valuation, losing upside.

Convertible Notes vs. SAFE Agreements

In recent years, SAFEs (Simple Agreement for Future Equity) have become an alternative to convertible notes. Both delay valuation, but there are key differences:

Bottom line:

• Convertible notes favor investors, since they carry interest and repayment rights.

• SAFEs favor founders, since they avoid debt obligations.

• Both are valuable tools, but the choice depends on negotiation dynamics and investor preferences.

When Should Startups Use Convertible Notes?

Convertible notes are particularly useful when:

• You’re raising a bridge round before a larger Series A.

• You need quick capital without extensive legal paperwork.

• You want to incentivize early investors with discounts and caps.

However, if you’re working with accelerator programs or very early-stage angels, a SAFE might be a better choice due to simplicity and lower founder risk.

Best Practices for Founders and Investors

For Founders:

• Negotiate the Cap Carefully → Too low, and you give away too much equity. Too high, and investors won’t feel protected.

• Avoid Note Stacking → Having multiple notes with different terms creates a messy cap table.

• Plan for Conversion → Structure your note so it aligns with your anticipated next round.

For Investors:

• Always Push for a Cap → This ensures you aren’t overpaying if the startup skyrockets in value.

• Watch the Maturity Date → Avoid long timelines with uncertain conversion.

• Diversify Risk → Notes are high-risk—spread investments across multiple startups.

Real-World Use of Convertible Notes

Many well-known startups have raised early funds using convertible notes. For example:

• Airbnb raised its early seed round partly through convertible notes.

• Uber also used notes in early financing rounds to avoid premature valuations.

These examples show that convertible notes can be a stepping stone for startups on their way to multi-billion-dollar valuations.

Final Thoughts

Convertible notes remain one of the most popular early-stage financing tools for startups. They offer a practical compromise: founders can access capital quickly without locking in a premature valuation, while investors gain upside protection through discounts and valuation caps.

That said, convertible notes are not without risks. Founders need to watch dilution carefully, and investors must ensure they negotiate fair terms.

As the startup ecosystem evolves, SAFEs are gaining ground , but convertible notes still hold an important place in angel investing and seed financing.

For founders and angels alike, the key is understanding the mechanics, weighing the trade-offs, and structuring deals that set the stage for long-term success.