A convertible note is a debt instrument that converts into equity at a later financing event — typically the company’s next qualified priced round — rather than being repaid in cash. It is a hybrid security used predominantly in early-stage financings (pre-seed and seed) to raise capital without requiring the founders and investors to agree on a current company valuation, deferring that negotiation to the next priced round when the company has more data points to justify a defensible valuation.
Key economic terms include: (i) principal amount (the invested capital); (ii) interest rate (typically 4–8% per annum, accruing in kind rather than paid in cash); (iii) maturity date (typically 18–36 months, at which point unconverted notes become repayable or convert at a default price); (iv) valuation cap (a ceiling on the conversion valuation — if the next round prices above the cap, noteholders convert as if the round were priced at the cap, capturing the upside); (v) discount (a percentage discount to the next-round price — typically 15–25%); and (vi) MFN (most favored nation) clause (giving noteholders the benefit of more-favorable terms granted to subsequent note investors).
The cap and discount typically operate on a “better-of” basis: at conversion, noteholders receive the more favorable of (i) the discount applied to the priced-round share price OR (ii) conversion at the valuation cap. For example, a $1M note at a $5M cap with 20% discount converting into a $10M pre-money Series A: cap conversion yields ~2x the equity that discount conversion would (because the cap is half the priced valuation), so the cap dominates. At a $6M pre-money Series A, the discount and cap produce similar results.
Convertible notes have important advantages over priced equity: speed (5–10 page note vs. 100+ page financing documents); cost ($5K–$15K legal vs. $30K–$50K for priced rounds); valuation deferral (allowing more time for traction development); and simplicity for investors and founders alike. Disadvantages include: debt classification (notes are technically debt until conversion, creating balance-sheet and bankruptcy implications); maturity pressure (founders must close a qualified round before maturity or negotiate extension); interest accrual (compounds founder dilution at conversion); and conversion-mechanic complexity in multi-note scenarios.
The U.S. market has largely shifted from convertible notes toward SAFEs (Simple Agreement for Future Equity) — Y Combinator’s 2013 innovation that strips out the debt characteristics (no interest, no maturity, no repayment obligation) while preserving cap-and-discount conversion mechanics. SAFEs are simpler and founder-favorable; convertible notes remain common in jurisdictions outside the U.S., in larger rounds where investor protections matter more, and where local tax treatment favors debt over equity-like instruments. Vircon Legal advises founders on convertible note structuring — cap and discount calibration, interest and maturity term-setting, MFN scope management, conversion modeling, and the strategic choice between convertible notes, SAFEs, and priced rounds.