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).
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) 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 (a minimum round size set in the note), 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; accrued interest can add to convertible note dilution; (4) tax, stock received on conversion of a note is generally treated as acquired at conversion for § 1202, and whether a SAFE's holding period can start earlier depends on its tax treatment as stock, which is unsettled; (5) balance sheet, convertible notes are debt liability; SAFE classification depends on its terms. The choice depends on context: founder-friendly markets favor SAFEs; investor-friendly markets and bridge contexts favor convertible notes.
Section 1202 holding period
Section 1202 requires stock acquired at original issue for money, other property or services, and § 1202(f) carries over a prior holding period only when the stock is received on conversion of other qualified small business stock. A convertible note is debt, so stock received on conversion is generally treated as acquired at conversion, and the § 1202 clock starts then. Whether a SAFE's holding period can start at funding depends on whether the SAFE is treated as stock for tax purposes, a question without settled authority. For stock acquired after July 4, 2025, § 1202(a)(1)(B) allows a 50 percent exclusion after three years, 75 percent after four and 100 percent after five. Stock acquired earlier must be held more than five years.
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.
For Texas startups, the choice between a convertible note and a SAFE depends on the deal. SAFEs carry no interest or maturity date. Notes give investors creditor rights, and their maturity date can be used to reopen terms in a bridge. A company with notes outstanding has to track principal and accrued interest on the cap table, watch maturity dates, fit conversion into the round documents, and issue the notes under a Regulation D or other exemption. Investors look at interest accrual and dilution, the change-of-control payout if a sale comes before a qualified financing, the § 1202 holding period, and the accredited-status representations. A note that is neither repaid nor converted at maturity may be in default under its terms, which can complicate a later financing.