Convertible Note Terms Explained: Caps, Discounts and Interest
A convertible note looks short and friendly, but four small terms decide how much of your company an early investor ends up owning. This guide explains convertible note terms in plain English: the valuation cap, the discount, the interest rate and the maturity date, plus how they work together when the note finally converts into shares.
Key takeaways
- A convertible note is a loan that usually turns into shares at a future priced round instead of being repaid in cash.
- Its four core terms are a valuation cap, a discount, an interest rate and a maturity date.
- When the note converts, the investor typically gets whichever price is better for them: the cap price or the discounted price.
- Interest usually converts into extra shares, and the maturity date is where a friendly note can turn into a hard conversation.
- Model the conversion in a simple spreadsheet before you sign, so you know the dilution you are agreeing to.
Many founders meet convertible notes during a first raise or a bridge round between priced rounds. Bridge rounds are often structured as SAFEs or convertible notes, and while SAFEs get plenty of attention elsewhere, notes are still common, especially with angels and some lenders who like the familiar shape of a debt instrument. If someone has just sent you a term sheet with a cap, a discount and an interest rate, this is the guide to read with a coffee and a calculator.
A quick note: this article is general information about startup financing, not legal, tax or investment advice. Note terms and their tax and legal effects vary by country and by document, so have a startup lawyer review anything before you sign.
What a convertible note actually is
A convertible note is a short loan from an investor to your company. Instead of paying it back with interest in cash, the expectation is that the loan converts into equity when you raise a priced round, usually a seed or Series A where investors buy shares at a set price per share.
Why use a note at all? Because it lets you take money now without agreeing on a valuation today. A note pushes that question to a later date, when a lead investor in the priced round sets the price. The early note holder gets rewarded for taking the earlier risk through the cap and the discount.
Because it is legally a debt, a note also carries debt features that a SAFE usually does not: interest that accrues over time and a maturity date by which the note is due. Those two features are why founders should read a note more carefully than its length suggests.
The four terms that matter most
Most convertible notes come down to the same four levers. Each one changes how many shares the investor receives at conversion.
Valuation cap
The valuation cap sets the maximum valuation at which the note converts. If your priced round happens at a valuation above the cap, the note holder converts as if the company were valued at the cap. That gives them a lower price per share than new investors pay, and therefore more shares for their money.
Think of the cap as protection for the early investor. If your company grows fast and your next round is priced high, the cap makes sure the person who backed you early does not pay almost the same price as someone who arrived once the risk was lower.
Discount
The discount gives the note holder a percentage off the price per share paid by new investors in the priced round. A 20% discount, for example, means the note converts at 80% of the new share price.
Interest rate
Because a note is a loan, it accrues interest. In most startup notes, that interest is not paid in cash. Instead, it is added to the amount that converts, so the investor receives a few more shares at conversion. Check whether interest is simple or compounding, because compounding grows faster over a long note.
Maturity date
The maturity date is when the loan is technically due. If you have not raised a priced round by then, the note does not convert automatically in most cases. What happens next depends on the wording: the investor might extend the note, convert at a pre-agreed valuation, or, in theory, ask for repayment. Read the maturity clause closely.
Pro tip
Ask your lawyer to add a clear "what happens at maturity" clause, such as an option to convert at a stated valuation or an automatic extension by agreement of a majority of note holders. Clear terms now prevent a stressful negotiation later.
How the cap and discount work together
Most notes include both a cap and a discount, and the investor gets whichever one produces the lower price per share. They do not stack. Here is the logic in three short steps.
- Find the round price. This is the price per share the new investors pay in the priced round.
- Calculate the discount price. Multiply the round price by one minus the discount. A 20% discount means round price times 0.8.
- Calculate the cap price. Divide the cap by the pre-money valuation of the round, then multiply by the round price. In practice the exact formula depends on how the note defines the company's capitalization, so your lawyer's model is the final word.
- Pick the lower price. The note converts at whichever price is lower, which means more shares for the investor.
- Add interest. Add accrued interest to the original amount, then divide the total by the conversion price to get the number of shares.
If your round is priced low, the discount usually wins. If your round is priced well above the cap, the cap usually wins. That is why founders who expect strong growth tend to focus their negotiating energy on the cap.
A worked conversion example
Hypothetical example
Priya runs a small software startup. She raises $200,000 on a convertible note with a $4 million cap, a 20% discount and 6% simple interest. All of these numbers are made up for illustration. Eighteen months later, she raises a priced seed round at an $8 million pre-money valuation, with new investors paying $1.00 per share.
The discount price is $1.00 times 0.8, or $0.80. The cap price is $4 million divided by $8 million, times $1.00, or $0.50. The cap price is lower, so the note converts at $0.50.
Interest for 18 months at 6% simple is $200,000 times 6% times 1.5, or $18,000. The total converting amount is $218,000. Divided by $0.50, the note holder receives 436,000 shares. If the note had converted at the discount price instead, they would have received 272,500 shares. The cap made a big difference.
A note terms comparison template
Copy this table into a spreadsheet and add a row for each offer you receive. All amounts are made-up examples.
| Offer | Amount (example) | Cap (example) | Discount | Interest | Maturity | Shares at an $8M round (example) |
|---|---|---|---|---|---|---|
| Angel A | $200,000 | $4,000,000 | 20% | 6% simple | 18 months | 436,000 |
| Angel B | $200,000 | $6,000,000 | 15% | 5% simple | 24 months | 293,333 |
| Bridge from existing investor | $150,000 | No cap | 25% | 4% simple | 12 months | 208,000 |
For Angel B, the cap price is $6 million divided by $8 million, or $0.75, while the discount price is $0.85, so the cap wins: $220,000 including interest divided by $0.75 is about 293,333 shares. For the uncapped bridge, the discount price of $0.75 applies to $156,000, giving 208,000 shares. Add a column for "percentage owned after the round" once you know the full share count.
Other clauses worth reading
The four core terms get the attention, but a few other clauses can change the deal just as much.
- Qualified financing threshold. Many notes convert automatically only when you raise a priced round above a minimum size. If your round is smaller, the note may not convert, so check the number.
- Change of control. If the company is sold before the note converts, this clause sets what the investor receives, often a multiple of the original amount or conversion at the cap. Read it so a modest acquisition does not surprise you.
- Most favored nation. This lets the note holder adopt better terms you give to later note investors. It is reasonable, but it means you cannot quietly offer a sweeter deal to someone else.
- Pro rata rights. Some notes give the investor the right to invest more in the next round to keep their percentage. That can be helpful or crowd out new investors, depending on demand.
- Security and subordination. Most startup notes are unsecured. If a note asks for security over company assets or a personal guarantee, slow down and get advice.
Common mistake
Stacking several notes with different caps and forgetting how they add up. Each note looks small on its own, but together they can convert into a surprisingly large slice of the company at your seed round. Keep one running model of every note and update it each time you sign another.
How to negotiate note terms as a founder
Negotiation is normal, and a polite, prepared founder is usually respected for it. Focus on the terms that matter most for your situation.
- Know your priorities. If you expect fast growth, the cap matters most. If you expect a slower path, the maturity clause and interest rate deserve more attention.
- Trade, do not just ask. You might accept a slightly lower cap in exchange for no interest, or a longer maturity in exchange for a higher discount.
- Keep terms consistent. Offering the same terms to everyone in a round keeps the paperwork simple and avoids awkward most favored nation issues.
- Plan the next round. Ask yourself what valuation you realistically expect at your priced round and run the conversion at that number and at half of it.
Convertible notes in the UK and Europe
Convertible notes are most associated with US startups, but they appear in the UK and Europe as well, often called convertible loan notes or convertible loan agreements. One important point for UK founders: investments that are structured as debt generally do not qualify for SEIS or EIS investor tax relief, which require shares. If your investors want those reliefs, an advance subscription agreement or a straightforward equity round may suit them better. Rules are detailed and change from time to time, so check GOV.UK and ask an adviser before you choose an instrument.
Across Europe, the legal form and tax treatment of convertible loans vary by country. Use a local lawyer who regularly works with startups and ask them which structure local investors expect.
Your convertible note checklist
- Confirm the amount, valuation cap, discount, interest rate and maturity date
- Check whether interest is simple or compounding and how it converts
- Read the maturity clause and agree what happens if no round closes in time
- Check the qualified financing threshold and change of control terms
- Look for most favored nation and pro rata rights
- Confirm the note is unsecured and carries no personal guarantee
- Model conversion at your expected round valuation and at half of it
- Add every note to one running conversion model
- Have a startup lawyer review the final documents before signing
Frequently asked questions
Is a convertible note better than a SAFE?
Neither is better in every case. A SAFE has no interest or maturity date, which many founders prefer. A note is a debt, which some investors like for its familiar protections. Choose based on what your investors expect and what your lawyer recommends for your country.
Do I have to repay a convertible note in cash?
Usually the intention is conversion, not repayment. However, if the note reaches maturity without converting, the investor may have a right to repayment depending on the wording. That is why the maturity clause deserves careful reading and, ideally, a clear conversion or extension option.
Can a note have a discount but no cap?
Yes. An uncapped note with only a discount is friendlier to founders, because the investor's price rises with your valuation. Investors often push for a cap in return for the early risk they take, so expect to discuss it.
Does accrued interest really matter?
It can. On a large note held for a long time, interest can add a meaningful number of extra shares at conversion. Include it in your model rather than treating it as a rounding error.
Related reading
The bottom line
Convertible note terms come down to four levers: the cap, the discount, the interest rate and the maturity date. The investor usually converts at the lower of the cap price or the discounted price, with interest adding a few more shares, and the maturity clause decides what happens if your priced round takes longer than planned.
Before you sign, put every offer into the comparison table, run the conversion at a couple of realistic round valuations, and ask a startup lawyer to check the details. A short spreadsheet session this week can save you from a dilution surprise at your next round.
