How convertible loan notes work — a concise primer

Convertible loan notes (often shortened to “convertible notes”) begin life as debt: an investor loans money to a startup under a written note that specifies principal, interest, and a maturity date. Instead of repaying cash at maturity, the note typically converts into equity at the next qualified financing round under pre-agreed terms — most commonly a discount to the new round price and/or a valuation cap that limits the conversion price.

This hybrid structure makes convertible notes attractive early-stage: the startup gets urgent capital without negotiating a company valuation, and investors gain downside protection (debt priority) plus upside through equity conversion.

(For a related document that often governs these deals, see our term sheet summary.)

Key elements of a convertible loan note

  • Principal: The amount the investor lends.
  • Interest rate: Often modest (common market ranges historically 4–8%), which accrues until conversion or repayment.
  • Maturity date: A deadline when the note must convert or be repaid (commonly 12–36 months).
  • Discount rate: A percentage discount off the per-share price at the next qualified round (typical discounts 10–30%).
  • Valuation cap: An upper bound on the company valuation used to calculate the investor’s conversion price, ensuring early backers get a favorable price if the startup’s valuation rises.
  • Qualified financing trigger: The financing event size (e.g., $1M+) that forces or allows conversion.
  • Conversion mechanics: How the principal and accrued interest translate into shares (sometimes via simple conversion or SAFE-like mechanics).
  • Change-of-control terms and repayment priorities: What happens on a sale, merger, or liquidation.

Tip — the term sheet that precedes or accompanies notes often defines many of these items; read it closely and consider legal review (see our term sheet summary for more on negotiation points).

Two small numeric examples (illustrative)

Example A — Discount-only conversion

  • Investor lends $100,000; discount = 20%.
  • Next round price = $1.00 per share.
  • Conversion price = $0.80 per share (20% discount).
  • Shares issued to investor = $100,000 / $0.80 = 125,000 shares.

Example B — Valuation cap vs. discount (cap often wins)

  • Investor lends $100,000; discount = 20%; valuation cap = $3M.
  • New round: company raises at a $6M pre-money, $3.00 per share.
  • Cap implies conversion price = $3M / (shares outstanding) — effectively a lower price than the discounted price; the note converts at the more favorable (lower) price for the investor.

These examples show why caps and discounts materially affect ownership after conversion.

Why founders use convertible notes (benefits)

  • Speed and cost: Notes are faster and cheaper than priced equity rounds because they avoid immediate valuation negotiations and extensive shareholder agreements.
  • Flexibility: Terms can be simple and tailored; often used for bridge financing.
  • Alignment of incentives: Early investors are rewarded for risk via discounts/caps, aligning them to support future growth.

From my work advising early-stage teams, founders value the reduced legal friction and the ability to close investor commitments quickly when runway is tight.

Why investors use convertible notes (benefits)

  • Downside protection: As debt, notes usually rank ahead of equity on repayment in a liquidation scenario.
  • Upside optionality: If the startup does well, notes convert into equity at attractive prices.
  • Simplicity for angels: Many individual angels prefer convertible notes over complex negotiated equity deals.

Common risks and drawbacks

For founders:

  • Dilution surprises: Multiple notes with different caps/discounts can create unexpected dilution at conversion.
  • Maturity pressure: A looming maturity date can force unfavorable terms or debt repayment if a financing event hasn’t occurred.
  • Covenants and investor protections: Notes can include terms (e.g., pro rata rights, board observer seats) that affect control.

For investors:

  • Illiquidity: Conversion depends on a later financing; if it never happens, recovery can be limited.
  • Recharacterization risk: If the instrument is treated as equity or if terms are unclear, investors may lose debt protections.

Tax and accounting considerations (high-level)

Convertible notes have tax and accounting implications that vary by instrument specifics and jurisdiction. Common points to discuss with a CPA or tax attorney:

  • Interest income: Accrued or paid interest is generally taxable to the investor as ordinary interest (U.S. federal rules). The issuer may deduct interest if it is treated as debt for tax purposes, subject to tax code limitations (consult IRS guidance and a tax professional).
  • Debt vs. equity classification: The IRS and accounting standards examine the instrument’s substance and terms when deciding if it’s debt or equity. Recharacterization can change tax, withholding, and reporting obligations (see IRS resources on debt vs. equity classification).
  • Original issue discount (OID): If issued below face value or with conversion features, OID rules may apply and affect taxable interest recognition.

This area is complex and fact-specific; always consult a tax professional and your accountant for the current rules and filings (IRS, and your state tax authority). I routinely recommend early conversations with tax counsel when drafting note terms.

Negotiation points and drafting tips (practical strategies)

  1. Be explicit about conversion triggers: Define what constitutes a “qualified financing” and the minimum raise that triggers conversion.
  2. Clarify cap vs. discount interaction: Decide whether the investor receives the better of the cap price or discounted price.
  3. Plan for maturity outcomes: Spell out whether notes convert automatically at maturity, can be extended, or must be repaid.
  4. Treatment on sale or IPO: Define acceleration, conversion, or payout mechanics on a change of control or IPO.
  5. Pro rata and anti-dilution rights: Decide whether early investors get rights to follow-on rounds.
  6. Consider SAFE vs. convertible note: A SAFE removes debt mechanics and interest but has different investor protections; choose based on your capital strategy.

For guidance on negotiating loan terms, our article on negotiating loan terms provides practical tips and checklists.

Common mistakes I see in practice

  • Vague conversion language: Ambiguous terms cause disputes and delay future rounds.
  • Ignoring cumulative caps: Multiple notes with different caps can produce unexpected ownership outcomes.
  • Failing to model dilution: Founders often underestimate how large note conversions cumulatively dilute founders and employees.
  • Skipping tax review: Missing how interest accrues or taxable events trigger can create unpleasant surprises at conversion or sale.

When I help founders, I insist on scenario modeling (best, base, and down-case) for each set of note terms before closing.

When to choose a convertible note vs. priced equity or SAFE

  • Use convertible notes when you need short-term bridge capital but expect a near-term priced round.
  • Use a SAFE when you want an ultra-simple instrument without debt characteristics (but be mindful of investor appetite).
  • Use priced equity when valuation, governance, and investor protections must be settled now (typical for later-stage financings).

Checklist before you sign or issue a convertible note

  • Confirm qualified financing thresholds and conversion mechanics.
  • Understand the interplay between discount and valuation cap.
  • Model post-conversion cap table under multiple scenarios.
  • Get tax and accounting guidance specific to your structure.
  • Have counsel draft or review the note and related term sheet.
  • Maintain clear communication with investors about milestones and timelines.

Resources and further reading

Professional disclaimer

This article is educational and reflects general practice observations. It does not constitute legal, tax, or investment advice. Convertible instruments can have complex tax and securities consequences; consult a licensed attorney and a CPA for advice customized to your facts.

Author note: In my practice advising founders, clear drafting and early tax consultation have prevented the most costly conversion disputes. When in doubt, model outcomes and get counsel.