Drafting and negotiation of convertible note instruments for early-stage financing.
Debt today, equity tomorrow
A convertible note is a debt instrument, it accrues interest and has a maturity date, that is designed to convert into equity, typically at the company's next priced financing round, rather than being repaid in cash. It gives investors downside protection through debt status while preserving the upside of eventual equity conversion.
Core terms
- Interest rate: accrues over the life of the note and is typically added to the converting principal.
- Maturity date: the date by which the note must convert, be repaid, or be extended.
- Conversion discount and valuation cap: mechanics similar to a SAFE, rewarding early investment relative to the priced round.
- Qualified financing threshold: the minimum size of a future round that triggers automatic conversion.
What happens at maturity
If the company has not raised a qualifying priced round by the maturity date, the note's terms govern what happens next: automatic conversion at a set valuation, an extension, or, in principle, repayment, which is rarely practical for an early-stage company that has deployed the funds. Maturity provisions should be negotiated with this reality in mind.
Notes versus SAFEs
Notes are more heavily negotiated instruments than the standardized SAFE, reflecting their debt characteristics: interest, maturity and potential default remedies. Investors sometimes prefer notes for the additional protections; founders sometimes prefer SAFEs for their simplicity and absence of a maturity deadline.
Process
- 1
Negotiate terms
Agree on interest rate, maturity, discount and cap.
- 2
Draft
Prepare the note consistent with the company's capitalization and other outstanding instruments.
- 3
Monitor maturity
Track the maturity date and plan for conversion, extension, or repayment well in advance.
- 4
Convert
Execute conversion mechanics when a qualifying financing or maturity event occurs.
Answers
Frequently asked questions
- What is the main difference between a convertible note and a SAFE?
- A convertible note is debt, carrying an interest rate and a maturity date, while a SAFE is not debt and has no maturity date or interest. Notes generally carry more creditor-like protections for the investor as a result.
- What happens if a note matures before a priced round occurs?
- This depends on the note's specific terms: options may include an automatic conversion at a set valuation, an extension of the maturity date, or, less commonly and often impractically, repayment. These provisions should be negotiated with a realistic view of the company's likely trajectory.
- Does the interest on a convertible note get paid in cash?
- Typically not before conversion. Interest usually accrues and is added to the principal that converts into equity, rather than being paid out in cash during the note's term.
- What is a qualified financing threshold?
- It is the minimum amount a future financing round must raise to trigger the note's automatic conversion provisions, distinguishing a genuine priced round from a smaller interim raise.
- Can a convertible note be extended past its maturity date?
- Yes, if the noteholder and company agree, typically through an amendment extending the maturity date and, sometimes, adjusting the interest rate or conversion terms in exchange.
Official sources
Consult the official sources above for current rules and procedures.