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Convertible Note: How do they work?

As a founder, you need to raise money to give reins to your business, and perhaps among the options you have heard on the internet, you have come across convertible notes.

From the beginning, this fundraising option promises to be fast and efficient when building capital for your first steps, but what is it about, and how does it work?

Well, we are going to decipher all these doubts within this article.

Please continue reading. 

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What is a Convertible Note?

If your startup is ready to start seeking funding but has yet to establish an established valuation, opting for a convertible note may be the most suitable option for you. 

This process consists of receiving a loan that you will later pay in the form of equity. In other words, you will not repay this loan in dollars with interest. Instead, give a part of your company's stock to the lender once your business reaches the established milestone or is ready for second fundraising. Read this complete guide on digital marketing funnel and then choose the right digital marketing channel for your business.

Convertible notes are an excellent option for you because:

  • They are a simple and fast solution
  • Lawyers and investors are familiar with it
  • It helps you delay valuation until the subsequent financing round

Why do Startups Use Convertible Notes?

In the first instance, the reason is apparent. Startups look for this debt instrument to be able to grow their business in the first states and then open their horizons to new forms of fundraising for their company.

Even so, the convertible note has another series of benefits that make this option more attractive for startups, among them we have.


Unlike other traditional debt instruments, which have fixed terms and interest rates, these notes give you a more accessible range of negotiation with investors in which both can agree on the terms of the loan, including the interest rate, conversion price, expiration date, so that it is beneficial for both parties.


Unlike equity financing, which can involve complex legal and regulatory processes, convertible notes are often traded on faster and less cumbersome terms. This characteristic benefits all startups that need to raise funds quickly.


This debt tool allows you to convert notes into equity for a later date. This benefit is also suitable for investors since they can work together to support the company's growth without buying shares. If the company's stock rises, the investor can convert the note into shares at a discounted price, potentially earning a profit.

How do Convertible Notes Work?

Many startups want to go with a convertible note because they are so early in their process and have no idea of their company's value on the market or even how much the shares they will offer as equity would be worth. Even this startup may be an idea when opting for one of these notes, and with the help of this loan, you will give value to the startup in the future. Check these Amazon FBA tips to grow your business and see how optimising your Amazon listing could help you grow. 

So, in summary, the convertible note is a loan that will be paid in due time in the form of equity from your company to the lender. The maturity date is usually exposed in the contracts, and once the goal is reached, the investor will obtain part of your stock as a payment method, adding an interest that both parties will establish in the first phases of negotiation. This process differentiates it from a traditional loan, where you must pay the value in dollars plus added interest.

Now, in writing, it may sound easy, but let's say that this process takes several steps to complete:

  1. Find an investor who is willing to invest through a note.
  2. You and the investor discuss the note's terms, mainly a discount rate and a cap.
  3. It is advisable to meet with a lawyer and other financial advisors to create the contract for the convertible note.
  4. Investors approve the note.
  5. They deliver the money.
  6. You take care of building your startup with that loan.
  7. After a while - and if things have gone well - you find investors to do an equity round and agree on terms for the 'qualifying financing round' in which the note converts from debt into shares.
  8. At this time, your first investors get shares or equity in the company, usually on the same terms as the new investors, and then both become part of your cap table.
  9. The convertible note has already been settled for this part; you can eliminate it.

To illustrate it better, let's give an example of how a convertible note works:

So, suppose an investor gives you $100,000 on a convertible note. Great, that's a good start.

This $100,000 will come with a 15% interest rate and a maturity period of 1 year.

What does this mean?

Well, this means that after one year, you will have to pay that note plus that 15%, being $115,000.

Making a jump in time, we assume that you have grown enough as a startup throughout this year. You've done so well that you feel ready for another funding round, like a series A fundraiser. This series A fundraising is a price round that will finally allow you to value your company at a specific price.

So, now that you know how much your entire company is worth, you will also learn how much a share of it will be worth. It is at this time that you can now pay your original investor.

For this, you will have to give him the original $100,000 plus 15% interest, all this in the value of shares of your company.

Warning: It is good to note that these notes can represent a risk for your startup if you do not take advantage of them properly.

Remember that at the beginning of this negotiation, a maturity date will be imposed that you must fully comply with. If you do not manage to have a well-established price or reach the second fundraising by said date, this breach could lead to problems or even bankruptcy for your company.

The term can be renegotiated and extended on certain occasions, but we recommend using the resources they give you. Read this guide on E-commerce supply chain and voice search optimization.

Convertible Note Terms.

With this in mind, there are specific terms that you should know when applying for a convertible note, and these are the following:

Discount Rate

This percentage refers to the investor's price for the loan conversion. This factor is the one that most motivate them to make the loan since, as a benefit, they end up paying a lower price than other investors in the subsequent equity round. So, if the discount is 20% and shares are sold for $1 per share during a later investing round, the investor's stock will be priced at 80 cents per share.

Valuation Cap.

This factor refers to the pre-money amount the loan converts to equity. This factor is especially important for investors since it gives them the security that their investment will convert into equity at a beneficial valuation. If your company is worth $10 million and the valuation cap is $1 million, the $100,000 investment would be 10%, not just 1%.

Interest Rate.

This interest refers to what the investor will receive in exchange for his loan. However, unlike other loan methods, this is lower since the investor takes on additional risk by loaning a startup. This rate is the one we exemplify above with the 15% interest rate, which is usually established in the negotiation stages.

Maturity Date.

This term is the deadline by which you must repay the debt or convert it into equity. These terms are usually between 1 year to 18 months.

Benefits of Convertible Notes

At first glance, we can see that the benefits of convertible notes over other loan options are their speed, simplicity and that they can be repaid in the long term with equity. However, we are going to expand these benefits further in this section.

Simpler Legal Procedures.

Paperwork and legal procedures are something necessary, but at the same time, so annoying. We understand; we all wish we could give you a "skip intro" to this part of the negotiations, but even so, you know that it is essential so that there are no legal loopholes in these negotiations.

Luckily the documents referring to these notes are much simpler. For the most part, these are usually templates in which the lawyers only add some numbers and names. In general, all these details come together quickly, leaving everything to do with equity deals for last.

It's Cheaper than Equity Funding Rounds

It is good to point out that convertible notes require fewer expenses than a round of venture capital prices; since their documents are uncomplicated, you will not have to spend a lot of energy and money to renew said contracts. A round of equity financing consists of many more documents, such as certificates of incorporation, operating agreements, shareholder agreements, and voting agreements, among others. So compare the scale and see how much you will be saving in lawyer fees. It's quite a lot!

Delay Pricing Discussion

Many startups choose convertible notes since these give them a chance to delay the valuation of their company since, in the beginning, they have not demonstrated much progress in product development or revenue. When they give investors a discounted price for future equity, startups can push the valuation decision later.

Disadvantages of Convertible Notes

Since we have seen the benefits, you can opt for a convertible note now, but wait since any loan comes with some cons that we should analyze. Therefore, to help you make the final decision, it is good to look at these notes' disadvantages.

Some Investors don't like to invest in Convertible Notes.

It's sad to admit, but many investors out there are not willing to invest in convertible notes. The main reason: they don't know how much they can earn from this deal.

Failure to Secure Future Financing

In the business world, you must be clear that there is an opportunity to fail. Is it 50%? 20%? We don't know, but like everything in life, it is a possibility.

This risk is another reason why many investors refrain from convertible notes because if, at maturity, the startup doesn't make a profit, the investor won't recover their money, and if your business is in a precarious situation, you will probably not be able to pay this debt.

 Therefore, the worst scenario looms bankruptcy.

Whatever the case, most negotiations of this type usually propose a plan between the founders and the investors so that they can achieve all the proposed goals, so it is always better to have a well-stipulated plan before starting the process.

Giving Away Shares of Equity

Many startups don't like equity as a negotiation term because they could give a considerable part of "the cake" that could be more valuable than the original loan. This scenario is more often when the valuation cap is low. So, if you face the best-case system and your startup faces notorious growth, you would give up a large percentage of your equity, resulting in a bittersweet feeling.

Final Thoughts.

Any startup in its first steps, or even if you only have the idea of one, could benefit from a convertible note since, as we saw, you don't have to pay upfront. Everything is decided on the maturity date.  

It is good to highlight that opting for one of these notes cannot be a leap of faith; that is, when looking for investors, you must have at least perspective and a plan of approximately one year so that, in case of being approved, you can make the most of it. As we said before, certain investors do not believe much in this option given the uncertainty generated by the possibility of not receiving their investment in return, but we are sure that if you provide them with a well-structured plan, they could approve your project.

Ultimately, the best thing in these cases is to study all your financing options as a founder, and we offer you all the articles we are writing about startups.

If you want more advice with digital marketing, contact our team of specialists to receive the guidance that will lead you to success. Contact us now!

FAQS - Frequently Asked Questions

What exactly is a convertible note and why is it beneficial for startups?

A convertible note is a form of short-term debt that converts into equity, typically in conjunction with a future financing round; essentially, the investor loans money to a startup and instead of getting a return in the form of principal plus interest, the investor receives equity in the company. The benefits of a convertible note for startups include simplicity and speed of the transaction, minimal negotiation on valuation at an early stage when it might be difficult to determine, and less dilution upfront compared to immediate equity financing. This financial instrument is particularly advantageous for startups in their nascent stages, allowing them to leverage capital efficiently while focusing on growth and development before committing to a fixed company valuation.

How does the process of converting a convertible note into equity work?

The process of converting a convertible note into equity is triggered typically by a specific event, often the startup's next significant round of equity financing. The terms set forth in the convertible note will outline the conditions under which the conversion occurs, including the conversion rate, which may be influenced by a discount rate or valuation cap to reward early investors with more favorable equity terms. Essentially, the amount invested via the convertible note is used to purchase shares in the company during a subsequent financing round, converting the debt into equity at terms more favorable to the investor than those offered to new equity investors.

What are the main reasons startups prefer using convertible notes over other financing options?

Startups prefer convertible notes over other financing options for several key reasons: they offer a faster and more straightforward funding mechanism, require less negotiation on company valuation at an early and uncertain stage, and provide flexibility in financial structuring. Convertible notes allow startups to delay valuation discussions until a later financing round when the company's growth metrics and prospects may justify a higher valuation, reducing early-stage ownership dilution for founders.

Can you explain the key terms associated with convertible notes, such as discount rate, valuation cap, interest rate, and maturity date?

The key terms associated with convertible notes are critical to understanding their structure and appeal:

  • Discount Rate: This rate provides early investors with a discount on the price of shares compared to what is offered to new investors in a future financing round, acknowledging the higher risk they took by investing early.
  • Valuation Cap: A valuation cap sets a maximum company valuation at which the note will convert into equity, protecting the investor by ensuring they receive more shares if the company's valuation increases significantly at the time of conversion.
  • Interest Rate: While the primary intent of a convertible note is to convert into equity, it accrues interest over time, which is typically also converted into equity at conversion. The rate is usually relatively low.
  • Maturity Date: This is the date by which the convertible note must either be repaid or converted into equity. It puts a timeframe on the conversion event and encourages both parties to prepare for either outcome.

What are the steps involved in securing and converting a convertible note?

Securing and converting a convertible note involves several key steps: initially, the startup and investor will negotiate the terms of the note, including the interest rate, discount rate, valuation cap, and maturity date. Once the terms are agreed upon and the note is issued, the investment is made, providing the startup with the necessary capital. The convertible note will then accrue interest over time until a specified conversion event occurs, typically the startup's next round of equity financing. At this point, based on the predefined terms, the note will convert into equity, giving the investor shares in the company.

What makes convertible notes a faster and simpler financing solution compared to equity funding?

Convertible notes are considered a faster and simpler financing solution compared to equity funding primarily due to the streamlined negotiation process and deferred valuation determination. Since convertible notes do not require setting a company valuation at the time of the investment, they avoid lengthy and complex discussions that can delay funding. Additionally, the legal and administrative processes involved in issuing convertible notes are generally less burdensome than those required for equity financing, enabling startups to access capital more rapidly and with fewer upfront costs.

Are there any risks or downsides to using convertible notes for both startups and investors?

While convertible notes offer several advantages, there are risks and downsides for both startups and investors. For startups, the primary risk is the potential for future equity dilution when the notes convert, which can be significant if the company experiences high growth. Additionally, if the startup does not manage to raise further capital before the maturity date, it might face debt repayment challenges. For investors, risks include the possibility of losing their investment if the startup fails and the uncertainty around the eventual equity price, which depends on future valuation negotiations. Both parties must also carefully negotiate terms to avoid misaligned expectations and incentives.

How do convertible notes differ from traditional loans or equity investments?

Convertible notes differ from traditional loans in that they are designed to convert into equity under certain conditions, rather than being repaid with interest, reflecting an investment in the company's future growth rather than a fixed return. Unlike direct equity investments, convertible notes allow investors and startups to defer valuation discussions to a later date, reducing upfront negotiation complexity. This hybrid nature offers a blend of debt's structured return expectations with the growth-oriented investment philosophy of equity.

What legal considerations should be taken into account when issuing a convertible note?

When issuing a convertible note, legal considerations include ensuring compliance with securities laws, accurately documenting the terms of the note (such as conversion triggers, discount rates, valuation caps, interest rates, and maturity dates), and considering the impact on future financing rounds. Proper legal documentation is crucial to protect both parties' interests and clarify the conditions under which the conversion will occur. Additionally, startups should consider the potential dilutive impact of convertible notes on existing shareholders and ensure that the issuance is in accordance with the company's governance documents.

How can startups and investors negotiate the terms of a convertible note to benefit both parties?

To negotiate terms that benefit both parties, startups and investors should focus on achieving a balance that recognizes the investor's risk while preserving the startup's growth potential. Transparent discussions about valuation expectations, growth plans, and the strategic use of the invested funds can help align interests. Flexibility on terms such as the discount rate, valuation cap, and interest rate can facilitate a compromise that reflects the startup's current stage and future prospects. Establishing a clear understanding of conversion scenarios and outcomes is essential for a mutually beneficial agreement, fostering a strong partnership between the investor and the startup.

About Bruno Gavino

Bruno Gavino is the CEO and partner of Codedesign, a digital marketing agency with a strong international presence. Based in Lisbon, Portugal, with offices in Boston, Singapore, and Manchester (UK) Codedesign has been recognized as one of the top interactive agencies and eCommerce agencies. Awarded Top B2B Company in Europe and Top B2C company in retail, Codedesign aims to foster personal relationships with clients and create a positive work environment for its team.  

He emphasizes the need for digital agencies to focus on data optimization and performance to meet the increasingly results-driven demands of clients. His experience in digital marketing, combined with a unique background that includes engineering and data, contributes to his effective and multifaceted leadership style.

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About Codedesign

Codedesign is a digital marketing agency with a strong multicultural and international presence, offering expert services in digital marketing. Our digital agency in Lisbon, Boston, and Manchester enables us to provide market-ready strategies that suit a wide range of clients across the globe (both B2B and B2C). We specialize in creating impactful online experiences, focusing on making your digital presence strong and efficient. Our approach is straightforward and effective, ensuring that every client receives a personalized service that truly meets their needs.

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