Convertible Note

Convertible notes have several key terms that govern how the conversion works. The discount rate gives the noteholder the right to convert their debt into equity at a lower price than what new investors pay in the next round, rewarding early investors for taking on more risk. The valuation cap sets a ceiling on the price at which the note converts, protecting investors if the company's valuation grows significantly before conversion. Interest accrues on the note during its term, but rather than being paid in cash, it typically adds to the principal that converts into equity.

Convertible notes became popular because they are faster and cheaper to execute than priced equity rounds, which require a formal valuation and more complex legal documentation. They are particularly useful at the pre-seed stage when it is difficult to determine a company's worth. However, founders need to be mindful of how multiple convertible notes with different caps and discounts can interact at the time of conversion, as the resulting dilution can be significant and sometimes surprising if not modeled out carefully in advance.