Convertible note

A convertible note is a financial instrument—specifically, a loan that can later convert into company shares instead of being repaid as a traditional loan. This format is particularly popular for early investments as it allows flexibility and reduces the need to know company valuation precisely during early stages.

How does it work? Investor A gives $100,000 to a startup as a “convertible note”. Instead of being recorded as repayment obligation with interest, the contract says: “If the startup secures Series A financing valued at, say, $5 million, your $100,000 converts into shares at that valuation.” If Series A doesn’t happen within a set timeframe (say, 3 years), the convertible note becomes a regular loan requiring interest repayment.

Advantages: (1) No valuation needed—no need to know exactly the startup’s worth; (2) Faster—investor and founder can agree quicker as detailed negotiation isn’t required; (3) Aligned interests—investor has interest in success as with proper valuation, money converts at discount.

However, convertible notes have drawbacks: (1) Uncertainty—if startup never reaches Series A, debt with interest must be repaid; (2) Discount—investors typically receive discount (say, 20%) on Series A valuation, meaning founders retain less value; (3) Cap—common “caps” (limits) on highest valuation where notes convert, sometimes unfavorable for founders if startup grows more than anticipated.