Convertible Notes: Model the Conversion Before You Sign

A convertible note is a loan designed to become equity if a specified event occurs—usually the startup’s next priced financing. Until conversion, the company owes principal and interest; the note also has a maturity date. The principal normally equals the cash invested, while accrued interest may be repaid or converted into additional shares. Cooley’s primer describes these core mechanics.

For a technical founder, the useful question is not simply “note or SAFE?” It is whether the note funds a concrete milestone—such as production deployment, repeatable paid usage or a defensible infrastructure release—before its debt terms create pressure. Model the financing event, a late financing and no financing at all.

The terms that determine the outcome

Term	What it does	What to inspect
Principal	Records the cash borrowed	Total across every note, not one investor’s check
Interest	Increases the balance repaid or converted	Simple or compound; whether interest converts on the same terms as principal
Maturity	Sets when repayment may become due	Whether holders can demand cash, elect conversion or approve an extension
Qualified financing	Defines the round that triggers automatic conversion	Minimum new-money threshold and which securities count
Discount	Reduces the next round’s price per share for the noteholder	The exact percentage and whether it applies to principal plus interest
Valuation cap	Sets a ceiling used to calculate a conversion price	The capitalization definition—the denominator—not just the headline cap
Sale or change of control	Governs an acquisition before conversion	Cash repayment, a multiple of principal, conversion or a holder election
Amendment threshold	Determines who can change the notes	Majority calculation and terms requiring each holder’s consent
Default, security and subordination	Defines creditor remedies and priority	Whether the note is secured and where it ranks against other debt

A cap and discount usually do not stack. The note generally converts at whichever method produces the lower price per share and therefore more shares for the investor. Cooley describes common discounts as 15%–25%, but that range is context rather than a term to copy automatically; risk, maturity and the rest of the economics matter. A cap is also not the priced-round valuation, even though parties often use it as a valuation proxy. The size of the round and the cap can materially change post-conversion ownership, so compare caps using a cap-table model rather than the headline number alone. For current market context, see pre-seed valuation-cap benchmarks.

Worked conversion example

Assume:

• $500,000 principal
• 5% simple annual interest
• conversion after 18 months
• 20% discount
• $8 million valuation cap
• 6 million shares in the note’s defined capitalization immediately before the round
• $2 priced-round price per share

First calculate the amount converting:

$500,000 + ($500,000 × 5% × 1.5 years) = $537,500

Then calculate the two possible conversion prices:

• Discount price: $2 × (1 − 20%) = $1.60
• Cap price: $8,000,000 ÷ 6,000,000 = $1.3333

The cap produces the lower price, so the note converts into approximately:

$537,500 ÷ $1.3333 = 403,125 shares

This is not a full dilution calculation. The actual ownership percentage depends on the agreement’s capitalization definition, the new-money shares, other notes and SAFEs, the option-pool treatment and rounding. Run the model on a fully diluted cap table under at least three priced-round valuations and dates. Interest makes time part of dilution: in this example, waiting another six months adds $12,500 to the converting balance.

Maturity is a real operating constraint

A maturity date is not merely a target for completing the next round. It is when the repayment obligation comes due, although agreements often let majority holders request repayment, elect stock or approve an extension. If an early-stage company has not raised by maturity, it may not have cash to repay; the parties may instead extend the date or negotiate conversion. Those outcomes depend on the drafted repayment and conversion provisions, not on an assumption that investors will automatically extend.

Set the maturity date against a downside operating plan. A developer-tool company expecting enterprise conversions in 12 months should not treat that forecast as certainty: model procurement delay, slower implementation and a financing process that starts later than planned. If missing the milestone also means missing the round and facing debt maturity, one schedule has concentrated three risks.

Convertible note, SAFE or priced round?

A SAFE can defer valuation without creating an interest-bearing loan or maturity date. Cooley explains that a SAFE has neither accruing interest nor a maturity date and ordinarily remains outstanding until conversion, acquisition or liquidation. A convertible note retains those debt features. A priced round issues equity now and resolves price and investor rights now, but normally requires a fuller set of financing documents.

A note is therefore most coherent when debt is intentional—for example, an existing note financing needs a short extension, or a specific investor requires a debt instrument. A SAFE may remove maturity and interest administration, but it does not remove dilution or drafting risk. If considering one, compare the actual documents and model all outstanding instruments together; the SAFE-versus-QSBS analysis also explains why tax characterization should not be inferred from a label.

Founder review before signing

1. Build one conversion model. Include every note and SAFE, accrued interest, cap-table denominator, option-pool change and new-money shares.
2. Test three events. Model a qualified financing, a sale before conversion and maturity without financing.
3. Read the definitions. “Company capitalization,” “qualified financing” and “majority holders” control outcomes that the economic summary may hide.
4. Keep note terms coordinated. Different caps, maturity dates, seniority or side rights can complicate the next round and holder consent.
5. Confirm approvals and compliance with counsel. Convertible notes are securities, not an informal loan between supporters. For a US Rule 506(b) offering, the SEC says there can be no general solicitation; a Form D notice is due within 15 days after the first sale, and states may still require notices and fees. The exemption also imposes conditions on non-accredited investors.
6. Record the debt correctly. Coordinate legal, accounting and tax advice on interest, original-issue terms and conversion; Cooley warns that a note specifying no accrued interest may create adverse accounting and tax consequences.

The founder-friendly note is not necessarily the one with the highest cap. It is the one whose conversion math, maturity outcome and investor-control provisions remain acceptable under the downside plan—not only the round everyone hopes to raise.