Convertible Notes Explained: Interest, Cap & Discount

A convertible note is startup debt with an exit ramp built in. The company borrows cash today and, instead of repaying it, converts the loan into shares later — usually when a priced round finally sets a real valuation. That structure lets an early-stage company raise money without agreeing a valuation nobody has enough information to set fairly yet.

The mechanics look simple on the surface: invest now, convert later. In practice, a convertible note carries five interacting terms, a real repayment risk if nothing else happens in time, and a conversion formula that changes depending on which term ends up controlling. This piece walks through all of it, with a full worked example.

What a convertible note actually is

Legally, a convertible note is a loan. The company is the borrower and the investor is the lender, exactly as with any other debt instrument. It sits on the balance sheet as a liability, not equity, until the moment it converts. That single fact — debt first, equity later — is what separates a convertible note from a SAFE, which is neither debt nor equity at signing.

The conversion trigger is usually the company's next qualified equity financing: a priced round above some minimum size, where professional investors set an actual price per share. Some notes also convert on a sale of the company or a dissolution. Until one of those triggers fires, or the note reaches its maturity date, the investor is simply owed money, with a contractual right to turn that debt into shares instead of collecting cash.

That deferred structure is precisely why early-stage investors accept a note in the first place. Nobody at pre-seed or seed has enough evidence — revenue, retention, a real market signal — to argue confidently for a specific valuation. A convertible note sidesteps that argument entirely: the company gets cash now, and the actual price per share gets set later, by whoever prices the next round with real information in hand.

The five terms that define a note

Every convertible note is built from the same handful of terms, and each one changes the outcome for both sides.

• Principal — the actual cash invested, before any interest.
• Interest rate — usually low single digits up to around 8% a year, accruing rather than paid in cash.
• Maturity date — typically 18 to 24 months from closing, the deadline by which the note must convert, get repaid, or get extended.
• Valuation cap — the maximum company valuation used to price the note's conversion, protecting the investor from a late, expensive round.
• Discount rate — a fixed percentage off the priced round's own share price, usually 15-25%.

US-based notes often anchor their interest rate close to the IRS applicable federal rate so the loan isn't treated as below-market for tax purposes — one more compliance step a SAFE avoids by not being debt financing at all.

Simple interest, and why the rate rarely moves much

Note interest is almost always simple interest, not compounding. That matters more than it sounds: simple interest grows in a straight line off the original principal, while compounding interest grows off an ever-larger balance. A 6% simple rate over two years adds 12% to the converting balance in total; a compounding rate would add slightly more. Term sheets are usually explicit about which one applies, and simple interest is the market norm for a reason — it's easier for both sides to check the maths without a spreadsheet.

The rate itself tends to sit in a narrow band, roughly 2% to 8% a year, because it isn't really meant to compensate the investor for risk the way a normal business loan's interest rate would. Nobody is lending to a pre-revenue company expecting a market return in cash interest. The rate exists mainly to convert into a few extra percentage points of equity if the round takes a while to arrive, which is exactly what the worked example below shows.

A note's core terms in one place

Why maturity dates carry real risk

This is the part a SAFE doesn't have, and it's worth taking seriously. When a note's maturity date arrives and no priced round has happened, the company is technically in default on a loan. The note's terms usually spell out what happens next: the investor can demand repayment of principal plus accrued interest, agree to extend the maturity date, or force conversion into equity at the cap even without a qualifying financing round.

None of those conversations are ones a founder wants to have while also trying to close a delayed round. A seed-stage founder we've seen run this had a note maturing at month 20 with the Series A still six months out; the fix was a negotiated three-month extension in exchange for a slightly lower cap on the remaining principal, but it cost weeks of legal back-and-forth that a SAFE would never have triggered. For the full side-by-side on how a SAFE avoids this deadline entirely, see SAFE vs convertible note.

How conversion math actually works

When a note converts, its calculation runs on the converting balance, not the original principal. Interest accrues over the time the note is outstanding and gets added to principal first; that combined figure is what actually converts into shares.

Where a cap and a discount both exist, the note converts at whichever term produces a lower price per share for the investor, since a lower price buys more shares for the same money. Work out both prices, take the lower one, and that's the conversion price actually used.

Discount rate vs valuation cap: which one actually bites

Early in a note's life, the discount rate is usually the term that controls, simply because the eventual round price is still unknown and far off. As the company grows and a priced round comes into view at a higher valuation, the fixed valuation cap tends to take over instead, because a fixed dollar cap stops moving while the round's own price keeps climbing. That's the whole logic of carrying both terms at once: the discount protects the investor when growth is modest, and the cap protects them when growth is strong enough to make a simple percentage-off discount look stingy by comparison.

Worked example: a note with accrued interest converts

A company raises $250,000 on a convertible note: 6% simple annual interest, an $8,000,000 valuation cap, and a 20% discount. Fourteen months later, a Series A prices the company at $2.00 per fully diluted share, against 6,666,667 shares outstanding before the note converts.

Notice what the interest did on its own: $17,500 of accrued interest bought an extra 14,583 shares at that conversion price, on top of whatever the principal alone would have purchased. That's money the investor never wired — it's the cost of the company taking 14 months to reach a priced round instead of closing one immediately.

Convertible note vs equity: why this stage skips a price at all

The whole point of a convertible note vs equity financing is timing. Pricing equity outright means agreeing a valuation, and at pre-seed or seed stage, neither side has enough information to set one confidently — too few data points, too much uncertainty about product-market fit. A note (or a SAFE) defers that valuation question to a later date when a professional investor is actually pricing a round, while still letting the company raise cash now.

That's also why notes are structured as debt rather than as some intermediate equity class: debt is a well-understood legal form that doesn't require deciding how many shares to issue until conversion actually happens. For the mechanics of how a comparable instrument handles that same deferred-pricing problem without debt, see how a post-money SAFE actually converts and pre-money vs post-money valuation for how the eventual priced round sets the numbers a note's cap and discount are measured against.

Where notes still make sense today

The post-money SAFE, introduced by Y Combinator in 2013, has become the default for US seed rounds because it skips interest calculations and maturity-date negotiations entirely, closing faster and cheaper. Notes haven't gone away, though. They remain common on bridge rounds between two priced rounds, where existing preferred shareholders and their counsel already think in debt terms, and in jurisdictions where a SAFE isn't a recognised standard instrument. Investors who want the contractual comfort of a repayment right, rather than an open-ended wait for a conversion trigger that might never fire, also tend to push for a note over a SAFE.

Standardised templates still make notes easy to paper quickly when they're the right tool: both the NVCA and Cooley GO publish widely used convertible note forms alongside their SAFE equivalents, so choosing a note doesn't mean starting the legal drafting from a blank page.

Whichever instrument ends up in your data room, the underlying discipline is the same: know your principal, your rate, your maturity date, your cap, and your discount before you sign, and run the conversion numbers rather than assuming a cap alone tells the whole story.

Model your own note or SAFE terms — principal, interest, cap, discount, and the exact ownership they convert into — with Foundily's free SAFE calculator, no signup required.