What Is a Convertible Note? A Founder's Guide

Before a startup can sell equity, someone has to agree on what the company is worth — and at the earliest stage, that's nearly impossible to do fairly. The company is an idea, a prototype, a tiny bit of traction. Convertible notes were invented to sidestep that problem: raise money now, decide the valuation later, when there's something real to price.

For years the convertible note was the default instrument for early raises, and it's still widely used. But it carries baggage that catches founders off guard — it's technically debt, with an interest rate and a deadline. Understanding how a note works, and how it differs from the SAFE that largely replaced it, is essential before you sign one.

This guide explains what a convertible note is, how conversion works, what the discount and valuation cap actually do, and how notes stack up against SAFEs.

What a convertible note is

A convertible note is a short-term loan to your startup that is designed to turn into equity rather than be paid back in cash. An investor hands you money now; instead of repaying it, you agree that when the company raises its next priced round, the loan converts into shares. It's a way to take investment today while postponing the hardest early question — what is the company worth? — until there's a real round to set the price.

That deferral is the whole appeal. At pre-seed, arguing over a valuation is mostly guesswork; the note lets both sides agree "we'll let the next, larger investor set the price, and you'll convert in alongside them on better terms." It's fast, cheap, and avoids a fight nobody can win yet — the same motivation behind the SAFE and a big reason notes became the early-stage default.

How conversion works

The note converts when you raise a qualifying priced round — typically a defined minimum size, like your seed or Series A. At that point, the note's principal (plus any accrued interest) turns into shares of that round. The conversion price is where the discount and cap come in.

1. You raise on a note today

   An investor lends, say, $100k on a note with a 20% discount and a $5M cap. No valuation is set now.

2. A priced round happens later

   Months on, you raise a seed round at a real per-share price set by a new lead investor.

3. The note converts at the better of two prices

   The note holder converts at the lower of (a) the round price minus the discount, or (b) the price implied by the valuation cap — whichever gives them more shares.

4. If no round happens by maturity

   The note either must be repaid or converts under fallback terms. This deadline is the part founders most often overlook.

The discount and the valuation cap

Both terms exist for the same reason: to compensate early investors for taking more risk than the people who invest later, once the company is more proven.

• The discount gives note holders a percentage off the next round's share price — commonly 15–25%. Invest early, pay less per share than the new money.
• The valuation cap sets a ceiling on the valuation at which their money converts. If your priced round values the company far above the cap, note holders still convert as if the company were worth the cap — so a low cap can mean a large ownership stake for an early backer.

Convertible note vs SAFE

The SAFE was created to strip away the parts of the convertible note founders disliked. The core difference is debt.

A note's interest and maturity date give investors more protection — and put more pressure on founders, because a maturity date that arrives before your next round creates a real problem. A SAFE has neither, which makes it simpler and more founder-friendly, the reasons it overtook notes for early raises. Both, though, use the same discount-and-cap machinery to convert into equity.

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Before you sign a note

• Know it's debt. Interest accrues and the maturity date is real — check what happens if you don't raise in time.
• Model the cap, not just the discount. The valuation cap usually drives how much equity converts.
• Compare to a SAFE. If you want simpler and more founder-friendly, a SAFE may fit better.
• See it on your cap table. Notes convert into shares later; know the dilution before you sign.

A convertible note is a useful, time-tested way to raise early money without pricing a company that's too young to price. Just go in clear-eyed: it's a loan with a deadline, the cap matters more than the discount, and a SAFE may be the cleaner tool for your situation. Either way, understanding the mechanics keeps you in control of your own cap table. When you're ready to meet the investors who fund rounds like these, Foundersbase connects founders and backers.