Convertible Notes Explained: Interest, Cap and Discount
Convertible notes explained in plain English: how interest, maturity, cap and discount work, how a note converts at your next round, and when to avoid one.
Convertible notes explained: a convertible note is a loan that is meant to turn into shares at your next funding round instead of being repaid in cash. The investor lends you money now, the loan earns interest, and the valuation debate waits until a later round sets a price.
Because it starts as debt, a convertible note has two features a SAFE lacks. It has interest, and it has a maturity date, which is the day the loan falls due. This guide explains each term, calculates a full example, and shows when a convertible note is a poor fit. In some countries the same instrument is called a convertible loan.
Convertible notes explained from the ground up
Pricing a company with no revenue is guesswork, and a lawyer-drafted share issue is slow and costly. A convertible note avoids both. The investor sends money under a short loan contract, and both sides agree on how the loan will convert once a real investor sets a price.
The note usually converts when you raise a qualified financing, which is a priced round that meets conditions written into the note. Those conditions can include a minimum amount raised, new investors, and fresh money only. Orrick, an international law firm, lists a qualified financing round as the standard trigger in German convertible loan agreements, with the end of the term and sometimes a sale of the company as other triggers.
Until conversion, the investor is a lender. The Dutch law firm Blenheim notes that such a lender is an unsecured creditor and that the loan shows as debt on the balance sheet. That status matters at maturity, as the later sections show.
The terms in a convertible note
Principal and interest
The principal is the amount lent. Interest is a percentage of the principal per year. In most startup notes the interest is not paid in cash. It is added to the amount that converts, so the investor receives more shares. Interest rates vary widely. Orrick reports rates of about 7 to 10 percent a year in current German practice, and the investor platform Ledgy says rates range from minimal to above 10 percent.
Maturity date
The maturity date is the day the note falls due. Orrick says pure bridge loans often run about six months and other convertible loans typically 12 to 24 months, and Ledgy gives 12 to 36 months as common. A company normally aims to convert the note into shares before the maturity date arrives.
Discount
The discount sets the conversion price below the price new investors pay. Orrick says discounts of 15 to 25 percent are typical, often around 20 percent, and that a discount applies whatever the valuation turns out to be.
Valuation cap
The valuation cap is the maximum valuation used to calculate the conversion price. It helps the investor only if the next round values the company above the cap. Ledgy gives a simple case. With a cap of 5 million and a round at 10 million, the note holder gets a de facto 50 percent discount.
Many notes include both a cap and a discount. The investor then takes whichever gives the lower price per share. The SAFE guide shows the same two terms in an instrument without interest.
| Term | Typical range | Effect on you |
|---|---|---|
| Interest | About 7 to 10% a year in German practice (Orrick) | Adds to the amount converted, so more shares |
| Maturity | 12 to 24 months (Orrick), 12 to 36 months (Ledgy) | A deadline to convert or repay |
| Discount | 15 to 25% (Orrick) | Cheaper shares for the note holder |
| Valuation cap | Set by negotiation | Limits the valuation used for conversion |
Worked example: a note converting at the next round
Example. Two founders hold 1,000,000 shares in total. An investor lends €200,000 on a note with 6 percent simple annual interest, a 20 percent discount and a pre-money valuation cap of €5,000,000. Twelve months later, the company raises a priced round. New investors put in €1,600,000 at €8.00 per share, which implies an €8,000,000 valuation for the 1,000,000 existing shares. To keep the numbers clear, there is no option pool and the round price stays at €8.00.
Step 1, interest. €200,000 × 6% × 1 year = €12,000. The amount that converts is €200,000 + €12,000 = €212,000.
Step 2, the discount price. €8.00 × (1 − 0.20) = €6.40 per share.
Step 3, the cap price. €5,000,000 ÷ 1,000,000 existing shares = €5.00 per share.
Step 4, choose the lower price. €5.00 is lower than €6.40, so the cap applies. The note converts into €212,000 ÷ €5.00 = 42,400 shares. With the discount alone it would have converted into €212,000 ÷ €6.40 = 33,125 shares.
Step 5, new investors. €1,600,000 ÷ €8.00 = 200,000 shares.
Step 6, ownership after the round. Total shares are 1,000,000 + 42,400 + 200,000 = 1,242,400.
| Holder | Shares | Ownership after the round |
|---|---|---|
| Founders | 1,000,000 | 80.5% |
| Note holder | 42,400 | 3.4% |
| New investors | 200,000 | 16.1% |
| Total | 1,242,400 | 100% |
The note holder paid €212,000 of principal and interest for shares worth €8.00 each in this round. 42,400 × €8.00 = €339,200, which is 1.6 times the converted amount, because €8.00 ÷ €5.00 = 1.6. That gain is the reward for lending early. The founders gave up 19.5 percent in total and should compare it with what they would have given up by selling shares at €8.00 on day one. The equity dilution guide explains how to run that comparison.
If no round comes. Suppose 18 months pass with no round and the note matures. Interest is €200,000 × 6% × 1.5 = €18,000, so the amount due is €218,000. Under the note, the investor may be able to demand repayment, or the parties may agree to convert at a price fixed in the note, or to extend. That is the main risk, and it leads to the next section.
When a convertible note is a poor fit
- You may not raise a round before maturity. Debt that falls due when you have no cash forces an extension, a conversion at a price you may dislike, or a default. A note works best when you can see the next round coming.
- You want clean accounts. The note is a debt on your balance sheet until it converts. A SAFE is not a loan, but how any instrument appears in your accounts depends on your accounting rules, so ask your accountant.
- Many small investors. Each note has its own interest and maturity date, so ten notes mean ten calendars to track and ten sets of terms to negotiate.
- You expect a big jump in value. A low cap hands the note holder a large discount on a company that grows fast, and interest adds to it.
- Your plan is a tiny bridge. For a few months of cash between rounds, a short note is common. Orrick describes bridge loans of about six months, some with interest only if the loan is not converted in time.
Keep notes on your cap table from day one
Unconverted notes are not on a share register, yet they will decide who owns what after your next round. Model each note with its principal, interest, discount and cap, so you see your real ownership before you negotiate. Our cap table guide shows how.
Frequently asked questions
Is a convertible note debt or equity?
It is debt until it converts. The investor is a lender with a claim to repayment, and the loan appears as debt on the balance sheet. After conversion, the investor is a shareholder.
What happens when a convertible note matures?
The note falls due. Depending on the contract, the investor can ask for repayment, both sides can agree to extend it, or the note can convert into shares at a price set in the document. Read this clause with your lawyer before you sign.
Does the interest on a convertible note get paid in cash?
Usually it is added to the principal and converts into shares, but the contract decides. Some notes require cash interest. Ask whether interest is simple or compounding, because compounding increases the amount that converts.
Which is better for founders, a convertible note or a SAFE?
A SAFE has no interest and no maturity date, which removes the deadline risk. A note is familiar to many investors, for example in Germany and the Netherlands, and may be the instrument they will accept. The right choice depends on your investors and on your country, so ask a local lawyer.
Can I negotiate the cap and the discount?
Yes. Every term is negotiable, including interest, maturity, discount and cap. Test each offer with a worked example like the one above, so you see how many shares you give away.
This is general education, not legal or tax advice. Instrument names, tax treatment of equity and the formalities of issuing shares differ by country. Check the details with a lawyer where your company is registered.
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