A convertible note is a loan from an investor that converts into preferred stock at your next priced round, usually at a discount or a valuation cap, whichever gives the note holder more shares. Because it is debt, it carries interest (commonly about 6% to 8% a year today) and a maturity date. For most pre-seed rounds a post-money SAFE is simpler, but a note still fits when the company is an LLC, an investor wants to hold debt, or you are raising a short bridge to a round that is already in sight.
If someone has put a convertible note on the table, you are probably close to taking your first outside money. Congratulations. Since 2008 we have helped hundreds of founders raise their first dollars, and the same handful of note terms come up every time. This guide walks through each one in plain English, with the math, so you can negotiate knowing what matters.
A convertible note is a promissory note with one extra feature. Instead of being repaid in cash, the principal and accrued interest convert into shares when the company raises a priced round. Until then, the note holder is a creditor of the company, not a stockholder.
Notes were the standard seed instrument for years before Y Combinator introduced the SAFE in 2013, and the post-money SAFE has since become the default. A SAFE is not debt: it has no interest and no maturity date, and it is shorter and cheaper to paper. So the real question for most founders is not “how do I do a note?” but “should this round be a note at all?” For the side-by-side comparison, see SAFE vs. Convertible Note vs. Priced Round, and for the SAFE itself, our Founder’s Guide to SAFEs.
There are three situations where a note is the better fit.
The first is an LLC. A standard SAFE assumes a corporation that will issue preferred stock in a later round. If your company is an LLC, a note (adapted to convert into membership units, or into stock if you later convert to a corporation) is usually the cleaner choice. If you plan to raise venture capital, read C Corp vs LLC first, because most venture investors will expect a Delaware corporation.
The second is an investor who wants debt. Some angels, family offices and non-US investors prefer to hold a creditor’s claim rather than a contract right. If the check matters and the investor is firm, a note is a reasonable accommodation.
The third is a short bridge. If you are raising a small amount to carry the company to a priced round that is already underway, a note’s maturity date puts little pressure on you, and some existing investors simply prefer to bridge on notes.
Outside those cases, we usually recommend a SAFE. Here is how the two compare on the points founders ask about most.
| Term | Convertible note | Post-money SAFE |
| Legal form | Debt | Contract right to future equity |
| Interest | Yes, about 6% to 8% simple | No |
| Maturity date | Yes, typically 18 to 24 months | No |
| Cap measured | Usually pre-money | Post-money |
| Documents | Term sheet, note, often a note purchase agreement | One short standard agreement |
| Works for an LLC | Yes, with adaptation | Not without significant changes |
Most note rounds use two or three documents. The term sheet is a short, nonbinding summary of the deal that frames what is being negotiated. In a pre-seed round, company counsel often drafts it. If a venture fund is leading, the fund may send its own. The convertible promissory note is the central document. It sets out the principal, interest, maturity, conversion and sale terms. Many rounds also use a note purchase agreement, which holds the company’s representations and warranties and the administrative terms, including how the notes can be amended. Some rounds fold everything into the note itself.
Behind those sits a board consent approving the form of note and the maximum amount to be raised. Notes can close on a rolling basis, so you can sign investors as they commit. See Can You Have Multiple Closings in a Startup Funding Round?.
Below is a sample term sheet with current market terms. Most of the negotiation in a note round happens at this stage, and once both sides agree, counsel drafts the documents to match. We walk through each term in the sections that follow. Bracketed items are placeholders.
Term sheet for convertible promissory note financing of [Company Name]
This term sheet is an expression of intent only, does not express the agreement of the parties, is not meant to be binding on the parties and is meant to be used as a negotiation aid. The parties do not intend to be bound until they enter into definitive agreements.
Issuer. [Company Name], a Delaware corporation (the “Company”).
Investors. Investors identified by the Company (the “Investors”). Amounts may be funded in multiple closings.
Notes. The Company will issue convertible promissory notes (the “Notes”) in exchange for the amounts invested.
Maturity. Unless earlier repaid or converted, outstanding principal and unpaid accrued interest will be due on request of the Majority Holders on or after the date 24 months after the initial closing (the “Maturity Date”).
Interest. Simple interest will accrue at 6% per year.
Conversion at qualified financing. If, while the Notes are outstanding, the Company sells shares of its preferred stock in an equity financing with aggregate proceeds of at least $1,000,000, not counting the Notes or other converting securities (a “Qualified Financing”), all principal and unpaid accrued interest will automatically convert into the shares sold in the Qualified Financing at the lower of (i) 80% of the price per share paid by the other investors and (ii) the price obtained by dividing $10,000,000 (the “Valuation Cap”) by the Company’s fully diluted capitalization immediately before the Qualified Financing. For this purpose, fully diluted capitalization includes all outstanding shares, options and warrants and all shares reserved under the Company’s equity incentive plan, including any increase made in connection with the Qualified Financing, and excludes shares issuable on conversion of the Notes, SAFEs or other convertible securities.
Conversion at maturity. At the Maturity Date, the Majority Holders may elect to convert all Notes into common stock at the price obtained by dividing the Valuation Cap by the fully diluted capitalization, calculated as above.
Change of control. If the Company is acquired before a Qualified Financing, each holder may elect either (i) a cash payment equal to 1.5 times the outstanding principal of its Note, in place of principal and accrued interest, or (ii) conversion of principal and unpaid accrued interest into common stock immediately before the closing at the price obtained by dividing the Valuation Cap by the fully diluted capitalization.
Prepayment. The Notes may not be prepaid without the written consent of the Majority Holders.
Security. The Notes are unsecured obligations of the Company.
Amendment. The Notes may be amended by the Company and the holders of a majority of the outstanding principal of the Notes (the “Majority Holders”).
Documentation. Documents will be prepared by Company counsel.
Expenses. The Company and the Investors will each bear their own legal and other expenses.
The issuer is the company raising money. The investors are the angels and funds buying the notes, often several of them, each on identical terms. Keep them identical: side deals for one investor make amendments and conversion messy later.
Some note investors, especially a fund leading the round, ask for a pro rata right in the priced round where the notes convert. That’s reasonable for a meaningful check. Limit it to that next round, since the priced-round documents will set pro rata rights going forward, and decide up front whether it’s measured by ownership after conversion or capped at a fixed dollar amount. Put it in a short side letter so the notes themselves stay identical. See Pro Rata Rights.
Before you take money from anyone, confirm who is accredited. Notes are securities, and the rules for selling them to non-accredited investors are much stricter. See Can My Startup Raise Money From Non-Accredited Investors?.
Like any loan, a note has a date when the principal and accrued interest come due. That is the maturity date, and it is typically 18 to 24 months after issuance. Unlike a car loan, there are no monthly payments. Everything is due at once.
Set the maturity date comfortably after the date you expect to raise your next round. If you plan to raise in 18 months, a 24-month maturity gives you room for the round to slip, which it often does. If the note converts before maturity, the maturity date stops mattering, because the debt is cancelled on conversion.
If the company reaches maturity without a priced round, the holders can technically demand repayment, which most startups cannot afford. In practice this rarely happens. Seed investors want large returns, not their principal back with interest, and the usual answer is an extension, covered below.
Early-stage notes are almost always unsecured, so note holders have no special claim on your IP or other assets, and a secured lender such as a bank is paid first. If an investor asks for a security interest, treat it as a sign they see the deal as a distressed loan, and talk to counsel before agreeing.
Interest on a note is usually simple, not compounding, and today commonly runs about 6% to 8% a year. That is higher than the 4% to 6% that was standard a few years ago, reflecting the higher-rate environment. Our sample term sheet uses 6%.
Seed investors do not invest for the interest. In almost every case, accrued interest converts into shares along with the principal, so its real effect is to give the note holder a slightly larger stake. A $500,000 note at 6% that converts after 18 months converts as $545,000. If an investor pushes for a rate well above the market range, or wants interest paid in cash, they are thinking like a lender rather than a startup investor, and that is worth a conversation before you sign.
The main way a note converts is at a qualified financing: a priced round of preferred stock that raises at least a minimum amount of new money. The threshold is often $1,000,000 or more, and it counts only new cash, not the notes converting. It keeps the notes from converting in a round too small to fund the company.
What if your priced round is real but smaller than the threshold? The notes won’t convert on their own, and new investors rarely accept unconverted debt sitting ahead of their preferred stock. Expect to ask the note holders to convert as a condition of closing, usually through a majority-holder amendment. Setting the threshold at a level tied to the size of the note round, rather than an aspirational number, avoids the problem.
When the notes convert, the note holders receive the same series of preferred stock as the new investors, with the same rights and preferences. That means when you negotiate the terms of your seed round, you are also setting the terms your note holders will get. For what a seed round looks like, see our Founder’s Guide to Seed Rounds.
How many shares the note holders receive depends on the discount and the cap. Time for some math.
The discount rewards the note holder for investing earlier and taking more risk. It lets them convert at a lower price than the new investors pay. The market norm is 20%, so the note holder pays 80% of the round price.
The formula is simple. The discount price equals the round price per share multiplied by (1 minus the discount). The number of shares equals the principal plus accrued interest, divided by the discount price.
Say an investor buys a $100,000 note at 6% interest with a 20% discount. Twelve months later the company raises a priced round at $1.00 per share. The note has grown to $106,000. The discount price is $0.80, so the note converts into 132,500 shares. Had the investor waited and invested $106,000 in the round, they would have received 106,000 shares.
A discount alone does not protect the early investor if the company’s value climbs quickly. Take the same $106,000 note, but suppose the company does so well that the round prices at $3.00 per share, a $30,000,000 pre-money valuation on 10,000,000 fully diluted shares. The discount price is $2.40, so the note converts into about 44,166 shares, well under 1% of the company. The investor took the earliest risk and ended up with a stake the size of a late check. The valuation cap fixes that.
The valuation cap sets a ceiling on the valuation at which the note converts. If the round prices the company above the cap, the note converts as if the valuation were the cap. The cap price equals the valuation cap divided by the company’s capitalization as the note defines it.
Two details matter. First, a note cap is usually measured pre-money, unlike the post-money SAFE, so the note holder’s final percentage depends on how much else converts at the same time and is not known until the round. Second, the note defines the share count used in the formula, and that definition moves the result. In our sample term sheet, the denominator is fully diluted capitalization including the option pool and any pool increase made in the round, but excluding the notes and other converting securities. A larger share count means a lower cap price and more shares for the note holders, so read the definition, not just the dollar figure. For more on caps generally, see Valuation Cap, and for how the share counts work, Equity Dilution.
The note holder does not get both. They get whichever produces the lower price per share, and therefore more shares.
Using our sample terms: an investor buys a $500,000 note with 6% interest, a 20% discount and a $10,000,000 pre-money cap. Eighteen months later the company raises a Series Seed at a $20,000,000 pre-money valuation, with 10,000,000 shares on a fully diluted basis, so new investors pay $2.00 per share. Accrued interest is $45,000, so $545,000 converts.
| Method | Price per share | Shares received |
| Discount (80% of $2.00) | $1.60 | 340,625 |
| Cap ($10,000,000 / 10,000,000 shares) | $1.00 | 545,000 |
The cap price is lower, so the cap applies, and the note holder receives 545,000 shares of Series Seed preferred. This is simplified. Real documents also decide whether the conversion shares sit inside or outside the pre-money share count, which changes the round price. Model the conversion on your actual cap table before you sign the note and again before you sign the term sheet for the priced round.
A cap far below the valuation you eventually raise at dilutes the founders and can put downward pressure on the next round’s price. A cap is not a valuation, and founders should not let investors treat it as one. It is a ceiling on the conversion price. Set it by working backward from the dilution you will accept, as we walk through in the Founder’s Guide to SAFEs, and keep the note round small.
The most founder-friendly note is uncapped with a discount: the investor is rewarded for early risk without anyone guessing at a value today. Many investors will not accept that, and a cap alone or a cap with a discount is far more common. If the investor wants both a low cap and a discount, push back on one of them and model both outcomes.
Usually not. The standard qualified financing definition requires a sale of preferred stock in a priced equity round, and a SAFE round is not one. If you issue notes and later raise on SAFEs, the notes keep accruing interest and keep their maturity date. If you want the notes to convert alongside the SAFEs, or into a later round on different terms, amend them with the required holder consent. Plan for this before you start the SAFE round, not after.
What happens if there is no qualified financing before the maturity date? Many notes give the holders, or sometimes the company, the right to convert at maturity, often into common stock or a series of preferred stock described in the note, at the cap price. In our sample term sheet, the majority holders can elect to convert into common stock at the cap. If the note is uncapped, the company and the holders will need to agree on a conversion price.
If the note does not provide for conversion at maturity, the only options are repayment or an extension. That is why the conversion-at-maturity clause is worth a careful read even though everyone expects the note to convert in a priced round first.
Most note purchase agreements let the company amend all the notes in a series with the consent of the holders of a majority of the outstanding principal. To extend maturity, the board approves a short amendment and the majority holders sign it before the maturity date passes. Every note in the series is then extended, including those held by investors who did not sign. Check your documents first, because some notes require each holder’s consent for changes to economic terms such as the cap or the interest rate.
If you have issued several series of notes with different maturity dates or conversion terms, a single omnibus amendment can bring them into line. It needs approval from the required majority of each series.
Need more money before the priced round? You can reopen the existing round on the same terms, usually with majority-holder approval, or sell a new series of notes. If the company has made real progress, a new series can carry a higher cap. Tell your existing holders either way.
Sometimes a company is acquired after issuing notes but before a priced round. That is usually good news for the founders, and the note decides what the note holders get. There are two common approaches, and many notes give the holder the choice.
The first is a cash payment, usually a multiple of the principal, commonly 1.5x to 2x. The second is conversion into common stock at the cap, so the note holder shares in the sale proceeds like any other stockholder. Our sample term sheet gives the holder the choice of 1.5x principal in cash or conversion at the cap.
Take the $500,000 note above, with $545,000 of principal and interest, and 10,000,000 fully diluted shares. Suppose the company is sold for $40,000,000 before any priced round. The cash option pays $750,000. The conversion option turns $545,000 at the $1.00 cap price into 545,000 shares of common stock, about 5.2% of the company, worth roughly $2,070,000 before fees and other adjustments. The holder will choose conversion. In a smaller sale the cash multiple wins, which is exactly what it is designed to do.
Small sales raise a different problem. In an acqui-hire, the buyer often wants most of the price to go to the team, and there may not be enough cash to pay the note holders their principal, interest and any premium. Raise this with the buyer early, and expect to ask the note holders to accept less. A majority-holder amendment clause makes that conversation much easier.
Negotiate this term at the start. Once a buyer is at the table, it is hard to change.
They still count. An outstanding note is debt that will convert in your priced round, and investors will find it in diligence. Before you start a priced round, gather every note, confirm its terms and accrued interest, and decide whether it will convert, be repaid or be amended.
Yes. A founder loan can be documented as a convertible note on the same terms as an outside investor’s, approved by the board with the founder abstaining as an interested director. Use real terms: a market interest rate and a cap consistent with the rest of the round. A below-market or interest-free loan to your own company can raise tax issues, so talk to a tax advisor about the rate.
Notes are not issued shares, so they do not count toward your fully diluted capitalization until they convert. Track them on a separate convertibles schedule in your cap table, with the issue date, principal, interest rate, maturity date, valuation cap and discount for each note. Update the accrued interest whenever you model a round, because interest keeps adding to the amount that converts. See What Is a Cap Table?.
Once the term sheet is agreed, counsel drafts the documents to match. Company counsel usually drafts in a pre-seed round, unless an established fund is leading. Notes are fairly standardized, but it is still in the founders’ interest for their own counsel to hold the pen. The biggest pitfall is counsel who does not do startup financings every day, which slows the deal and runs up costs.
After closing, update the cap table, collect signed copies and wire confirmations, and keep the board consent with your records. Depending on the type of fundraise, you may need to file a Form D and state blue sky filings. See What Comes After Fundraising?.
Who pays the lawyers? Each side should pay its own. In note rounds that is the usual practice, and our sample term sheet says so. Some investors, especially in larger rounds, ask the company to pay their counsel too. We think this term is unfair and should be removed from standard term sheets. Investors should pay their own legal fees.
A fee term means the company pays for the lawyer negotiating against it, out of the money it just raised, with no control over how long that lawyer spends. Propose that each side pays its own fees. If the investor insists, cap the amount at a fixed dollar figure and keep it as low as you can. See Who Pays the Legal Fees in a Startup Funding Round?.
For the SAFE alternative, read our Founder’s Guide to SAFEs. When your notes are about to convert, the Founder’s Guide to Seed Rounds and the Founder’s Guide to Series A cover the priced rounds that follow. To keep the company clean along the way, see How to Avoid Legal Startup Mistakes, and if you are building a mission-driven company, our Founder’s Guide to Public Benefit Corporations. For a shorter overview of notes, see Convertible Notes: What They Are and How They Work, and for SAFEs, SAFE (Simple Agreement for Future Equity).
We have been helping founders raise their first money since 2008, and we would be glad to help with yours. If you are raising on notes, extending or amending notes you already have, or deciding between a note and a SAFE, see our convertible note services or contact us.
