How Do Convertible Notes Work?

Whether you're a founder in PropTech or another industry, convertible notes can be an efficient way to raise capital for an early stage startup. Here’s a breakdown of how convertible notes work in a way that’s clear, actionable, and practical — especially from a founder's perspective.

What Is a Convertible Note?

A convertible note is a short-term debt instrument that startups use to raise capital. Unlike a traditional loan that gets repaid in cash, a convertible note converts into equity in the future. The key idea is that investors provide money upfront, and instead of getting their money back with interest, they get shares in your company when you raise your next funding round.

Think of it as a bridge between early funding and a proper equity round — a way to get cash in the door without the headache of agreeing on a company valuation early on.

Key Terms in a Convertible Note

Before diving into how they work, let’s cover a few key terms you’ll see in every convertible note:

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How Convertible Notes Work in Practice

Let’s walk through the three key stages of a convertible note lifecycle:

1. Initial Investment (Issuing the Note)

At the start, an investor gives your startup a loan — this is the principal amount. The investor and founder agree on terms like the interest rate, valuation cap, and discount rate.

For example:

An investor gives you $100,000.
The note has a valuation cap of $5M and a discount rate of 20%.

You don’t give up equity right away. The loan is essentially a promise to convert into shares later.

2. Conversion (Triggered by a Future Funding Round)

The convertible note converts to equity when you raise your next significant round of funding. This round is typically a priced equity round led by institutional investors.

Here’s how the conversion works:

Scenario 1: Valuation Cap Applies

If the valuation of your company at the next round is higher than the valuation cap, the convertible note converts at the cap.

Example:

You raise your next round at a $10M valuation.
But the investor’s note has a $5M valuation cap.
The note converts at the $5M valuation cap, giving the investor more equity than they would have received at the $10M valuation.

Scenario 2: Discount Rate Applies

If the valuation is lower than the cap, the note converts at a discounted price based on the agreed discount rate.

Example:

You raise a round at a $4M valuation.
The note has a 20% discount.
The investor’s note converts at 80% of the $4M valuation (effectively valuing the company at $3.2M for the investor).

3. Maturity Date (If No Trigger Event Happens)

If no conversion event happens by the maturity date, the investor has a few options, depending on the terms of the note:

Convert to equity at a default rate.
Extend the maturity date.
Request repayment. (This is rare — most investors don’t expect repayment in cash.)

Why Use Convertible Notes?

Pros for Founders:✅ Fast and simple to execute.
✅ No need to agree on valuation early on.
✅ Deferred dilution until your next equity round.

Cons for Founders:❌ Can be expensive if the valuation cap is too low.
❌ Accrued interest increases the investor's equity stake.
❌ Future dilution risk if multiple notes convert at once.

Convertible Notes vs. SAFEs (Simple Agreements for Future Equity)

Many startups now use SAFEs instead of convertible notes because SAFEs are simpler — they don’t accrue interest or have a maturity date. However, some investors still prefer convertible notes because they provide more protection.

Example: How Convertible Notes Impact Equity

Let’s walk through a quick example of how a convertible note converts into equity in a future funding round.

Scenario:

Investor gives you $100,000 via a convertible note.
The note has a $5M valuation cap and a 20% discount rate.
You raise a Series A at a $10M valuation.

Here's what happens:

Without a valuation cap, the investor would get 1% of your company (because $100,000 / $10M = 1%).
With the $5M valuation cap, the note converts at a $5M valuation, giving the investor 2% of your company (because $100,000 / $5M = 2%).

Pro Tips for Founders

Negotiate the Valuation Cap Carefully.
The valuation cap is the most critical term for founders. A low cap can mean significant dilution in your next round.
Watch Out for Stacking Convertible Notes.
If you issue multiple convertible notes, they can stack up and dilute your ownership significantly once they all convert.
Consider Using SAFEs Instead.
If you’re looking for a simpler option with less complexity and investor control, consider a SAFE. It’s often more founder-friendly.

How Do Convertible Notes Work?