What is a Convertible Note? A Simple Guide for Angel Investors

You are prepared to invest in your first startup. The founder is reputable. The presentation is thrilling. You are supportive of the vision. 

Next is the paperwork. You hear words like “SAFE,” “equity round,” and yes—“convertible note.” Wait. What is a convertible note?

Well, you are not alone. Numerous new angel investors experience the same. Here, we're going to lay it out in simple terms. You'll leave here knowing what convertible notes are, how they work, and when it makes sense to use them. Let's get started.

What Is a Convertible Note?

A convertible note is a short-term debt that is convertible into equity in a future period.

Rather than getting shares immediately, you provide the startup with a loan. Sometime later, that loan “converts” into equity—most often during the startup's next round of funding. That's it. Debt that turns into ownership.

You're sparing the founder the headaches of establishing a valuation too early. And in return, you get to be first in line for equity, usually at a discount.

Why Use Convertible Notes?

Convertible notes are widely used in early-stage investments, most notably in angel and pre-seed rounds.

Here's why:

1. Easy and Quick
   Early-stage startups generally lack time and resources to spend on haggling complex equity agreements. Convertible notes are low-weight, quick, and inexpensive to draft.
   
   
2. No valuation is required immediately
   Pricing a startup with no product, no revenue, and no traction is tough. A convertible note postpones that discussion until the next round of funding.
   
   
3. You Still Get Equity
   Although you are lending money, you're not anticipating cash repayment. You are wagering on ownership in the future.
   
   
4. Investor-Friendly Terms
   To compensate you for taking an early risk, convertible notes sometimes carry sweeteners:
   
   

• Discounts on a future round
• Valuation caps to control how high the price can go
• Interest rates (occasionally)
  
  

Key Terms in Convertible Notes

Here are the top terms every investor should know:

1. Valuation Cap

‍This establishes the highest valuation at which your note will convert.

Here’s an example:You put $50,000 in a note with a $5 million cap. Next round is valued at $10 million. Because of the cap, your money converts as if the company were worth $5 million, and not $10 million.

You get more equity for your money.

2. Discount Rate

‍This offers you a percentage reduction on the amount paid by fresh investors.
Average discount: 10% to 25%
So you might only pay $0.80 or $0.90 per share if new investors invest at $1 per share.

The idea? Get rewarded for being an early bird.

3. Interest Rate

‍Some convertible notes contain interest, typically ranging from 4%–8% per annum.
This interest does not pay you in money. It simply contributes to the loan amount that later turns into equity.

Your final ownership could be based on $52,000 instead of $50,000, depending on the note's term.

4. Maturity Date

‍This is when the note is due.
One of the following is expected to occur by that time:

• It converts to equity
• It is repaid (rare)
• It is lengthened

Investors are looking for specificity regarding when their loan becomes convertible. Founders desire flexibility. This is a point of negotiation.

How Convertible Notes Operate in Real Life

Let's go through a brief example:

• You invest $100,000 in a startup through a convertible note.
  
  
• The note carries a valuation cap of $4 million and a discount of 20%.
  
  
• The startup raised a priced seed round of $8 million a year later.
  
  
• You convert your note at that time.
  
  
• You do not pay the price of $8 million. Instead, your investment is converted at the lower of the cap or discount rate.

Let us analyze that:

• Cap Value: $4M valuation
  
  
• Discount Price: 20% off $8M = $6.4M
  Cap is a good bargain.

Since $4M is lower, your note converts at that price. So, your $100K converts as if you invested at a $4 million valuation. That gives you 2.5% ownership of the company ($100K ÷ $4M), assuming a simple cap table and no other terms like accrued interest.

How Convertible Notes Impact Your Ownership

One of the most critical and perplexing aspects of convertible notes is how it affects your ownership stake. You don’t know exactly how much equity you will purchase when you invest through a convertible note. Your ownership isn’t definitive until the note is converted.

The percentage you arrive at is based on:

• The valuation cap or discount factor
• The startup’s next valuation
• Whether or not interest is accrued and compounded on your investment

Let’s understand it through the example explained before.
You invest $100,000 at a cap of $4 million.
If the startup raises a priced round at $8 million, your investment will convert at the cap, and you will own approximately 2.5%.

But if the company raises at a lower valuation—perhaps $5 million—then you'll receive a bit more equity.

The Bottom Line:
You are not entitled to a set % like in a priced equity round. Your share is a function of future events. That makes it even more crucial that you grasp the terms and do your due diligence. It's not just about supporting a good founder. It's about whether your slice of pie is worth the gamble.

Convertible Note vs. SAFE: What's the Difference?

You might be familiar with SAFEs (Simple Agreements for Future Equity). They function a lot like convertible notes with a significant exception: SAFEs aren’t debt.

They have no maturity date, and typically no interest. They are simpler and even founder-friendly. However, convertible notes provide investors with greater legal safeguards, since they are in the form of loans.

In practice, both are typical. And both translate to equity in the next round.

Pros and Cons of Convertible Notes

Pros for Investors:

• Speedy entry into an agreement.
• More favorable terms (cap and discount) for initial risk.
• Potential interest against your loan.
• Seniority status in case things do go wrong.
  
  

Cons to Investors

• Uncertainty regarding when (and whether) conversion will occur.
• Limited control over company decisions.
• Complexity regarding maturity dates and legal terminologies.
• Risk of never succeeding if the startup collapses or is unable to raise again.
  
  

Like any investment, convertible notes are risky. However, they offer upside if the company is successful.

Are Convertible Notes Safe?

Let's be clear: Convertible notes are not exactly "safe" investments. They are high-risk, high-return ones.

You are investing in an early-stage founder with nothing but a pitch deck. You might never get your money back. However, if the company expands, your note can be converted into a significant equity stake, quite possibly on very favorable terms.

So, it is a matter of comprehending the risk and determining whether the reward value is worth it.

When Should Angel Investors Use Convertible Notes?

Convertible notes are reasonable when:

• The company is too premature to be priced.
• You want to act quickly on a transaction.
• You are trusting the founder, but need conversion protections.
• You are investing pre-seed or seed, before VCs come in.
  
  

They're less suitable when:

• The company can accommodate a priced round.
• You want greater control or clarity over ownership.
• You’re unsure about the next funding milestone.
  
  

Bottom line: Use convertible notes when speed and ease are more important than uncertainty.

Questions to Ask Before Signing a Convertible Note

Don't simply sign and wire. Ask the following first:

• What’s the valuation cap?
• Is there a discount? How much?
• What’s the maturity date?
• Is interest being charged?
• What initiates conversion?
• What if no next round exists?
• Will the note be converted into a sale or exit?
• Are MFN (Most Favored Nation) clauses present?

These questions assist in knowing how your money becomes equity and under what circumstances.

Convertible Notes: Friend or Foe?

For angel investors, convertible notes can be both.
If framed correctly, they're an excellent method to:

• Enter early
• Secure outstanding terms
• Ride the upside of the next round

But they are risky. No valuation, no control, and no assured conversion. That’s why it's so important to know what you're signing, and where it plays in your overall portfolio strategy.

Wrapping It Up: In Short, What Is a Convertible Note?

It’s a handshake with legal teeth.
A convertible note says:

“I believe in this founder. I'm early. Let’s avoid the valuation dance at this point but insist on equity down the road, and a good price when it comes time.”

Fast, flexible, and generally equitable, both to investors and founders.
However, like any tool, it will serve you best if you know how to utilize it.

Want to Go Deeper? Learn with Angel School

Understanding convertible notes is only the starting point. With our Venture Fundamentals course at Angel School, we guide you through the entire process of getting started with angel investing with confidence. From term sheets and deal structure to startup valuation and portfolio strategy, everything is covered in simple terms.

So if you are serious about becoming an early-stage smart investor, begin learning today.

Join our Venture Fundamentals course at Angel School and convert your interest into insight.

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