You’ve got some traction in your business. Perhaps you’ve raised funds through a couple of SAFEs, maybe not. Now you’re ready to grow further and need higher amounts of capital to do so. A convertible note may be the right instrument. But before you sign on that dotted line, understand what you’re signing. A convertible note is a loan. That one fact changes how you should read every line of it.

I’ve helped multiple founders raise through convertible notes. Here, I’ll explain the basic elements of a convertible note so you’re better positioned to determine whether it’s the right tool for your business.

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Why it matters: A note that converts cleanly may be valuable capital. A note that doesn’t convert is a debt your company owes, with interest, on a date you may not be ready for.

1. A convertible note is a loan. A SAFE is not. That’s the whole distinction, and it’s the one founders miss. A convertible note accrues interest and must be repaid if it never converts. A SAFE does neither. If the company stalls and nothing triggers conversion, the note becomes a bill while the SAFE just sits there. Decide which risk you can live with before you pick the instrument.

2. The maturity date and interest rate set your downside. The maturity date is the day you owe the investor the principal plus accrued interest if the note hasn’t converted. There are no monthly payments like a bank loan. Everything comes due at once, at the end.

The interest rate is usually simple, not compounded, and ranges from 4% to 6% per year.

Founders do have options to minimize risks, such as setting the maturity date slightly after you expect to close your next round, so conversion occurs before repayment comes due. If maturity arrives and the note hasn’t converted and you can’t pay, you can negotiate an extension. Convertible-note investors almost never foreclose to liquidate a startup, but don’t build your plan on their patience.

3. Discount and cap decide how many shares the investor gets. The note converts to equity when you raise a qualified financing, usually defined as a new round meeting a minimum dollar threshold, commonly $1 million market value, but negotiated. At that point, your note investors become preferred shareholders alongside the new money. Two terms control their price.

The discount is the reduction they get off the new investors’ price, usually 15% to 25%, most often 20%. Invest $100,000 at a 20% discount: if new investors pay $1.00 per share, your note investor pays $0.80 per share. In that case, their $100,000 buys 125,000 shares instead of 100,000.

The cap is the maximum valuation at which the note converts. If the cap is $10 million and the new round values you at $20 million, the note investor converts as if the company were worth half and gets far more stock than the new investors for the same dollars.

Many notes carry both. When they do, the investor gets whichever formula yields more shares. The most founder-friendly structure, although rare, is a discount with no cap, because it spares you from putting an early valuation on the company.

4. Plan for the scenarios nobody plans for. Qualified financing is the clean path, but there are two others.

At maturity, the note can convert to equity automatically or by exercise of an option. Push for that option to sit with the company, not the investor.

On a change of control, if you’re acquired before raising again, the investor usually chooses between a cash payout, commonly 1x to 3x principal plus interest, or converting to equity just before the sale at a preset valuation. Know which one before you sign.

One more thing: don’t pay their lawyers. Each side should cover its own legal fees, although some investors demand that the startup pay theirs as well. Try to negotiate it out.

The bottom line: A convertible note isn’t paperwork. It’s a loan with a clock on it. Read it that way, and you’ll negotiate from strength instead of signing from hope.

Further reading: Angel Capital Association Model Convertible Promissory Note

This guide is not legal advice. If you’re raising capital, work with a startup lawyer. If you don’t have one, reach us at www.ruta.legal.

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