Convertible Note
A debt instrument that converts to equity (typically preferred stock) upon a qualified equity financing, with a valuation cap, discount, or both. Convertible notes accrue interest (typically 4-8% annually) and have a maturity date (typically 18-24 months) at which they must be repaid or converted. Largely displaced by SAFEs in U.S. seed-stage financing but remain common in some contexts (later-stage bridges, more-investor-friendly markets, §1202 QSBS holding-period optimization).
A convertible note is a debt instrument that converts to equity (typically preferred stock) upon a qualified equity financing event, with a valuation cap, discount, or both. Convertible notes are debt instruments, they accrue interest (typically 4-8% annually), have a maturity date (typically 18-24 months), and must be repaid or converted at maturity. Convertible notes were the dominant early-stage U.S. financing instrument until SAFEs displaced them in the 2010s, but they remain common in later-stage bridges, investor-friendly markets, and contexts where the debt features (interest accrual, maturity leverage, §1202 holding-period start) are valuable.
Standard terms
Convertible note terms typically include: (1) principal amount, investment amount; (2) interest rate, typically 4-8% annually; simple or compound; (3) maturity date, typically 18-24 months; (4) conversion mechanics, qualified financing trigger ($1M+ minimum size standard), valuation cap, discount; (5) conversion price, generally lower of cap price or discount price; (6) change of control, typically 1x or 2x repayment, or conversion at cap, at investor option; (7) events of default; (8) subordination, to senior debt; (9) amendment provisions; (10) governing law.
Conversion at qualified financing
Convertible note conversion mechanics: (1) qualified financing trigger, equity financing meeting minimum size threshold; (2) conversion price, lower of cap price or financing price minus discount; (3) shares received, principal plus accrued interest divided by conversion price; (4) same securities, typically same series of preferred stock as financing investors (with possible exceptions for shadow series). Accrued interest converts alongside principal, meaning the longer the period before conversion, the more shares the investor receives.
Maturity date scenarios
If qualified financing has not occurred by maturity, several scenarios can apply (per note terms): (1) repayment, note becomes due and payable; (2) automatic conversion at fixed conversion price (e.g., cap price); (3) investor election between repayment and conversion; (4) extension if both parties agree; (5) default if not repaid and conversion option not exercised. Maturity creates negotiating leverage for investors, facing default exposure, founders may agree to renegotiate terms or convert on terms favorable to investors.
SAFE vs. convertible note comparison
Key trade-offs: (1) founder perspective, SAFEs are simpler (no debt, no maturity, no interest); convertible notes create maturity pressure; (2) investor perspective, convertible notes provide more protection (interest accrual, maturity leverage, default rights); SAFEs are cleaner but less protective; (3) cap table, both create future dilution at conversion; convertible note dilution is larger because of interest accrual; (4) tax, convertible notes start §1202 QSBS holding period at investment; SAFEs typically start at conversion; (5) balance sheet, convertible notes are debt liability; SAFEs are typically equity. The choice depends on context: founder-friendly markets favor SAFEs; investor-friendly markets and bridge contexts favor convertible notes.
The §1202 QSBS holding-period advantage
Convertible notes have a meaningful tax advantage over SAFEs for investors seeking §1202 QSBS exclusion: (1) convertible notes, §1202 holding period typically begins at note issuance (debt is exchanged for stock at conversion, but holding period tacks); (2) SAFEs, §1202 holding period typically begins at conversion since SAFEs are not stock. For investors expecting §1202 exit (5-year holding period for qualifying small business stock with substantial gain exclusion), convertible notes can save substantial tax. This advantage drives convertible note usage in some seed deals, particularly with sophisticated investors.
Common drafting issues
Recurring convertible note drafting issues: (1) qualified financing definition, minimum size, type of equity (preferred or any), inclusion of SAFE conversions; (2) cap calculation, pre-money or post-money basis; (3) interest rate, too low and investor return is inadequate; too high and dilution is excessive; (4) change of control payout, 1x or 2x principal, or conversion at cap; sophisticated investors push for higher payout; (5) amendment threshold, majority or supermajority required for changes; (6) most favored nation provisions. Each provision affects both parties' economics; careful negotiation is essential.
For Texas startups, convertible note vs. SAFE selection depends on context. Best practice: (1) for typical seed financings, SAFEs are simpler and market-standard; (2) for bridges between rounds, convertible notes provide structure and creditor protection; (3) for sophisticated investors expecting §1202 exits, convertible notes offer tax advantages; (4) for founders worried about maturity pressure, SAFEs avoid the issue; (5) for investor-friendly markets, convertible notes are commonly preferred. Best practice: (1) maintain comprehensive cap table tracking all outstanding notes and their conversion mechanics; (2) calendar maturity dates carefully, failures generate default risk; (3) coordinate convertible note conversion at qualified financing with broader round documentation; (4) ensure proper Reg D compliance for note issuance. For investors: (1) understand interest accrual and dilution implications; (2) evaluate change of control payout, important if exit precedes qualified financing; (3) coordinate §1202 holding period; (4) document representations on accredited status. Common pitfall: founders missing maturity date, generating default and creditor claims that complicate subsequent financings.