A convertible note is a short-term debt instrument that converts into equity at a future financing round, usually with a discount and a valuation cap.
Plain definition
A convertible note is a debt instrument issued to investors that converts into equity at a future financing round. It functions as a loan with an interest rate and a maturity date. The conversion happens automatically at the next qualified financing, usually at a discount to the round price or capped at a defined valuation, whichever produces a lower per-share price for the investor.
The instrument exists because pricing an early-stage company is hard. A convertible note lets investors fund the company without negotiating a valuation upfront. The valuation gets set later, by the priced round, and the note converts at terms that compensate the investor for taking the early risk.
A convertible note is a deferred valuation. The terms of the deferral, especially the cap and discount, decide what the founder actually paid for the early capital.
What goes wrong
Founders treat the valuation cap as a ceiling. Investors treat it as the price. When the next round prices below the cap, the cap is irrelevant. When it prices above, the cap is what matters, and the founder discovers the early capital cost more equity than the up-round headline suggested.
Convertible notes have maturity dates. If no qualified financing has happened by maturity, the note can convert at a default valuation, become equity at terms the founder may not want, or come due as repayable debt. Founders sometimes ignore maturity until it lands.
Most-favored-nation clauses in convertible notes promise the early investor any better terms given to a later note investor. A second note round at a lower cap automatically resets the first note investors to the lower cap. The discount stack compounds.
Multiple notes with different caps and discounts convert at the priced round. The waterfall of who converts at which price gets calculated by the lawyers and the founder reviews it for the first time at signing. Equity that looked like one number on the cap table becomes a different number after conversion.
Founder questions
Bigger picture
A SAFE is the cleaner cousin of the convertible note. Same conversion logic, no debt, no maturity, and a different post-money math problem.
Related structure Liquidation PreferenceNotes typically convert into preferred stock at the priced round. The preference attached to that stock decides what conversion is actually worth at exit.
Related structure Capital Raise That Cost ControlThe case pattern of early instruments compounding into a priced round inside a real founder-led company.
Related reading
How the choice of capital changes which protections sit on top of the cap table.
Related readingTiming decisions that shape what early instruments end up costing at the priced round.
Related readingWhy capital structure decisions made early decide what later rounds and exits actually pay.
Bring the notes, the cap and discount terms, and the proposed round structure.