Convertible notes explained: how they work, key terms and a worked example

A convertible note lets a startup take money today and settle the share price later. The investor writes a check, the company writes a promissory note, and the argument about what the company is worth waits for a priced round that has an investor with real money behind it. The cost of that delay is a contract with more moving parts than it first appears to have: interest, a due date, a discount, a cap and a conversion trigger.

This page explains each of those parts, walks one made-up note from signing to conversion with the share arithmetic shown, and compares the model terms with a note disclosed in an SEC filing. It belongs to the fundraising section; the closest neighbors are SAFE notes, which solve the same timing problem without debt, and how venture rounds work, where conversion actually happens.

Debt vs. equity: what a convertible note is

In the SEC’s glossary of common startup securities, a convertible note is a loan made by an investor to a company that can be converted into a different security¹. Notes are often used in seed rounds because of the difficulty of valuing a company early in its life¹. Typically the note converts automatically from debt into preferred stock of the company on the closing of the next funding round, or on other agreed conditions¹.

Until conversion, the holder is a lender. The University of Pennsylvania law clinic’s model note does not entitle the holder to any rights as a stockholder², and a startup-finance guide makes the practical point that holders typically have no voting rights before conversion⁴. Notes are generally characterized as debt before they convert². Debt can also be a security: depending on the type of debt, it may be classified as one¹, so selling notes to investors can be a securities offering, not a private loan.

How convertible notes work

The model note published by Penn’s Entrepreneurship Legal Clinic is a useful skeleton, because it separates the parts that are standard from the ones that are negotiated². Its sequence runs like this.

1. Money in. The investor lends the principal and the company issues a note; the principal plus interest is the debt that may later convert.
2. Interest accrues. The clinic's form uses simple interest on an annual basis, computed on a 365-day year².
3. A qualified financing arrives. The company sells preferred stock above a threshold set in the note, and principal plus accrued interest automatically converts at the lesser of the discount price and the cap price².
4. Or the company is sold first. The investor receives cash equal to principal and accrued interest².
5. Or the maturity date arrives. The note is repaid, extended or converted, depending on the note's terms and what the sides agree^{2, 3}.

The same few terms recur in every note, and each has a reasonable range in the sources. The ranges below come from commentary and filings, so they describe common practice, not a rule.

Interest rate

Interest is the least interesting economic term and the one most likely to be misread. Under the model note, interest accrues simple and converts with the principal into shares². Interest is usually paid at conversion⁴, and issuers benefit from reduced cash interest payments². For the investor, the main prize lies in the conversion rather than in the interest⁷.

Rates vary with the market and the stage. One startup-law comparison lists interest as often 2-8%⁵. A later-stage example from an SEC filing sits at the top of that range: HeartFlow’s 2022 notes bore 8% a year, compounded monthly⁶. Its 2025 notes did not accrue interest for the first year after issuance⁶, and afterward the interest is capitalized each year into the principal⁶.

State law can cap interest, which is why a note names its governing law. The clinic’s model note chooses Pennsylvania law². Delaware’s statute is a useful reference point. It lets lenders charge any rate agreed in writing up to 5% over the Federal Reserve discount rate⁸. The same chapter removes any limit where the amount lent exceeds $100,000 and repayment is not secured by a mortgage on a borrower’s principal residence⁸.This page covers Delaware only; other states have their own rules and exemptions.

Valuation cap

A valuation cap sets a ceiling on the company value used to price the conversion. It is the maximum valuation used to determine the note’s conversion price³. When a qualified financing happens, the note sets a price per share by dividing the cap by the number of shares outstanding just before that financing². If the company is worth far less than the cap, the cap may not be used².

A cap protects the investor from dilution if the company’s valuation soars⁷. For the founder it carries a trade-off, and the cost is concrete: a low cap set too early can create a large ownership transfer at conversion if the company outperforms, and can compress the effective valuation for Series A investors³.

The conversion discount

The discount lowers the price at which the note converts relative to what new investors pay. The clinic defines it as a fixed rate that reduces the price the investor pays for the equity securities on conversion². J.P. Morgan’s example: with a 20% discount the noteholder converts at $0.80 a share when new investors pay $1.00³.

Ranges differ by source and by year. One legal glossary reports discounts of 10% to 30%⁷, and a startup-finance guide puts the usual range at 15-25%⁴. HeartFlow’s 2025 notes use 20%⁶, and its 2022 notes converted at 67% of the round price⁶. The clinic’s model pairs a discount with a cap and converts at the lesser of the two².

A convertible note example, with the arithmetic

The example below is made up, with round numbers, and ignores an option pool, fees and tax. It shows how interest, discount and cap interact at a Series A.

Worked example (our arithmetic): a $100,000 note converting at a Series A (structure from²; the discount is the 20% used by³; every input is made up)

Our arithmetic: at a $2.00 round the cap beats the discount, and the noteholder buys 84,800 shares, not 66,250. At a $1.00 round the company is worth less than the cap, so the discount price is lower and the cap is not used, which matches the clinic’s point that a cap far above the company’s value may never apply².

Ownership after the $2.00 round (our arithmetic): if new investors put in $2,000,000 at $2.00, they receive 1,000,000 shares. Total shares are 4,000,000 + 84,800 + 1,000,000 = 5,084,800, so the note holds 84,800 ÷ 5,084,800 = about 1.67%. The effective price of $1.25 against $2.00 is a 37.5% reduction, which is why J.P. Morgan stresses that notes defer the pricing but not the dilution³.

Do you have to pay back a convertible note?

A convertible note is debt, so repayment is the default if the conversion never happens. The clinic’s model note makes principal and accrued interest payable on the request of the majority holders on or after a maturity date set at 24 months from the first closing². Maturity is generally set at one or two years from issuance², and J.P. Morgan puts the common range at 12-24 months³.

If the company has not raised a qualifying round by then, the holder may elect cash repayment or conversion into the company’s most senior class of stock². In practice the two sides usually negotiate repayment, extension or conversion³. Cake Equity’s guide adds that startups often extend the maturity date to avoid defaulting⁴. A note approaching maturity without a financing event forces a negotiation the founder may not be positioned to win³.

Worked example (our arithmetic): the same note at maturity (simple interest as in²; made-up amounts)

Default has teeth. The clinic’s annotations add that default events allow the noteholder to order immediate repayment of any outstanding debt². J.P. Morgan’s suggestion is to begin conversations with noteholders well before maturity, with a clear plan to convert or extend³.

What happens to a convertible note if the startup fails?

The noteholder ranks ahead of equity. Debt is repaid before any equity if the company is sold or wound down⁵. A SAFE issued before or after a note sits behind it in line⁵. The clinic’s model note is unsecured², which means the holder has a claim on the company but not on a particular asset. If the company has little left, a senior claim over equity does not guarantee payment.

A sale before the qualified financing works the same way. Under the model note the investor receives cash equal to principal plus accrued interest instead of shares². Thomson Reuters adds the investor’s view: the debt nature of the note lets an investor recover money as a creditor if the startup becomes insolvent⁷.

Convertible notes for investors

An investor holds three things at once: a creditor’s claim, a conversion right and, usually, a promise of a better price than new money gets. The discount and the cap are the compensation for taking the earlier risk⁷. The note carries none of an equity holder’s rights before conversion, including voting⁴. Interest matters less than conversion⁷.

The chapter on how venture rounds work covers the later round where the conversion lands.

Disadvantages of convertible notes

Most of the weaknesses show up for founders at conversion, and a few for investors earlier.

• Dilution is only postponed. Notes defer setting a valuation, not the dilution³.
• Debt has a deadline. An unpaid note falls due at maturity, and the company may have to repay, extend or convert on weaker terms³.
• Stacked terms. Each new note or SAFE with a different cap, discount or most-favored-nation clause adds conversion complexity that new investors must untangle³.
• Senior claims. A note issued under or over SAFEs ranks ahead of them⁵.
• Ownership uncertainty. Notes create uncertainty about future control and ownership, particularly when several notes convert at once⁷. Y Combinator also lists ownership as estimated until conversion⁵.
• Unintended outcomes. The clinic warns that notes can lead to outcomes the parties did not intend².

Y Combinator calls notes increasingly rare for new raises⁵, a position from an accelerator that promotes the SAFE, not market data.

Real terms from an SEC filing: HeartFlow

Public filings show how the same terms look at larger scale. In its 2025 registration statement HeartFlow disclosed two note programs⁶.

Two features stand out. Conversion price can be a percentage of the round price, as in 2022, or the lower of a discount and a cap, as in 2025⁶. And HeartFlow remeasured the 2022 notes at fair value immediately before conversion and recognized a $5.1 million loss from the change in fair value⁶.

Convertible note vs SAFE

The SAFE came after the note as a simpler cousin. A SAFE is an agreement to buy shares later, with no interest and no deadline⁷; a convertible note is a loan with interest and a repayment deadline⁷. SAFE notes covers the other instrument in the same detail.

Education only: ranges differ by source, and other states, loan sizes and security structures change the answers above.