Convertible Note

A Convertible Note in the United States records a borrower's unconditional promise to repay a stated sum to the lender on agreed terms.

A convertible note is classified as a debt security under federal securities law administered by the US Securities and Exchange Commission (SEC). The issuance of a convertible note constitutes an offer and sale of a security under Section 2(a)(1) of the Securities Act of 1933 (15 U.S.C. § 77b(a)(1)), which defines a security to include any note with a maturity exceeding nine months. To avoid registration with the SEC under Section 5 of the Securities Act, most convertible note issuances rely on exemptions from registration — most commonly the Rule 506(b) or Rule 506(c) exemptions under Regulation D (17 CFR § 230.501 et seq.) for offerings to accredited investors as defined in Rule 501(a), or the Section 4(a)(2) private placement exemption for limited offerings to sophisticated investors.

Startup companies issuing convertible notes must file Form D with the SEC within 15 days of the first sale under the Regulation D exemption, and may be required to file a notice with the securities regulator of each state where investors reside (blue sky filings) under state securities laws. Many states have adopted the Uniform Securities Act of 2002, which provides registration exemptions for securities sold to accredited investors that parallel federal Regulation D.

The convertible note defers the most difficult negotiation in early-stage financing — the valuation of the company — to a future financing round when the company has more operational history and market data to support a valuation. Unlike a priced equity round (such as a Series A), a convertible note can typically be documented in a few pages and closed within days of term sheet agreement, at lower legal cost. The primary investor protections in a convertible note — the valuation cap and the conversion discount — compensate the early investor for taking risk without the benefit of an immediate equity stake.

A convertible note differs from a SAFE (Simple Agreement for Future Equity), developed by Y Combinator and first published in 2013, in two legally significant ways. A convertible note is a debt instrument — it has a maturity date by which it must either convert or be repaid, it accrues interest, and it creates a creditor-debtor relationship that gives the investor priority over equity holders in a dissolution. A SAFE is not a debt instrument — it has no maturity date, accrues no interest, and does not create a creditor relationship. The SAFE is contractually simpler and has become the dominant seed financing instrument for YC-backed companies and many other US startups since approximately 2018, though convertible notes remain widely used — particularly for angel and micro-VC investments where investors prefer the creditor protections of a debt instrument.

A Convertible Note is needed whenever a US startup company raises seed or pre-seed capital from angel investors or early-stage venture capital funds and wishes to defer the company valuation negotiation to a future priced financing round.

Pre-seed fundraising — raising the first $50,000 to $500,000 needed to build a prototype or conduct initial customer discovery before the company has any meaningful revenue or traction — is the most common context for convertible note issuance. At this stage, there is insufficient operating history to support a defensible valuation, and both the company and investors may prefer to defer the valuation until the Series A round when the company has more data.

Bridge financing between priced rounds — where a company has closed a Series A or Series B but needs additional capital to reach its next milestone before raising its Series B or Series C — often uses convertible notes as a faster and less expensive alternative to a full priced round. Bridge notes typically offer the same or slightly improved economic terms compared to the last priced round, with a shorter maturity and a conversion at the next qualified financing.

Angel syndicates — informal groups of angel investors investing together through platforms such as AngelList, Republic, or Wefunder — frequently use convertible notes as the investment instrument because they are familiar, quick to document, and allow each investor to subscribe on the same terms without complex stockholder negotiations. The NVCA (National Venture Capital Association) model convertible note forms, available at nvca.org, provide a standard starting point for angel and seed investments.

Strategic corporate investors — established companies making corporate venture investments in startups to gain access to emerging technology or market intelligence — often use convertible notes for initial investments, with the option to convert to equity in a subsequent financing if the strategic relationship develops as anticipated.

Revenue-based financing hybrids — instruments that combine a convertible note structure with a revenue royalty or right of first refusal in favor of the investor — are increasingly common in sectors such as consumer products, SaaS, and healthcare technology, where investors want both downside protection (debt) and equity upside through conversion.

A US Convertible Note contains the following essential provisions that define the economics of the investment, the mechanics of conversion, and the rights of the investor until conversion or repayment.

The principal amount clause states the face amount of the note — the amount of cash being invested — in US dollars. Most seed-stage convertible notes range from $25,000 to $2,000,000, though notes of any size are legally permissible. For a convertible note round with multiple investors, each investor typically receives a separate note for their individual investment amount.

The interest rate and accrual clause specifies the annual interest rate (typically 5% to 8% per annum for seed-stage notes in 2024, though the rate has little practical significance since interest converts to equity rather than being paid in cash) and the compounding convention (simple interest or compound interest). Accrued and unpaid interest converts to equity alongside the principal at the conversion event, increasing the number of shares the investor receives.

The maturity date clause specifies the date by which the note must either have converted to equity through a qualifying financing or been repaid in cash if no conversion event has occurred. Typical maturities for seed convertible notes are 18 to 24 months from issuance. The maturity date creates deadline pressure on the company to raise its qualified financing and is a key investor protection.

The valuation cap clause sets the maximum pre-money valuation at which the note will convert into equity, regardless of the actual pre-money valuation in the qualifying financing round. If the qualifying financing values the company above the cap, note holders convert at the cap valuation — receiving more shares per dollar than new investors in the priced round. For a note with a $5 million cap converting in a Series A at $15 million pre-money, note holders receive three times as many shares per dollar as Series A investors. The valuation cap is the most economically significant term in a seed convertible note.

The conversion discount clause gives note holders the right to convert at a specified percentage discount to the per-share price paid by new investors in the qualifying financing. A 20% discount means note holders pay $0.80 for every $1.00 of value in the qualifying round. Where both a cap and a discount apply, conversion typically occurs at whichever method produces the lower conversion price (more favorable to the investor), though the parties may specify otherwise.

The qualifying financing definition clause specifies the minimum aggregate investment amount that must be raised in a single round for that round to constitute a qualifying financing that triggers automatic conversion. Most seed convertible notes set the qualifying financing threshold at $1,000,000 to $3,000,000, to prevent conversion in a small bridge round that would dilute note holders at an unfavorable price.

The most favored nation (MFN) clause protects the note holder against the company issuing subsequent convertible notes on more favorable economic terms. An MFN clause requires the company to offer the existing note holder the same improved terms if future notes include a lower cap, higher discount, or additional investor protections. MFN clauses are common in angel notes and are included in Y Combinator's Post-Money SAFE form.

The pro rata rights clause gives the note holder the right to participate in the qualifying financing — investing additional capital at the same price as new investors — to maintain their percentage ownership in the company. Pro rata rights are typically limited to note holders above a specified investment threshold (e.g., notes of $100,000 or more) and must be exercised within the offering window specified in the financing documents.

The events of default clause specifies what constitutes a default under the note — typically including failure to repay at maturity, insolvency, bankruptcy filing, material breach of note covenants, and change of control without note holder consent — and the investor's remedies upon default, which may include acceleration and demand for repayment of principal plus accrued interest.