Background and when founders use each option

Convertible notes grew popular because they let early-stage investors delay valuing a company until a later priced round, simplifying seed deals and closing faster. RBF gained momentum in the late 2010s as a nondilutive alternative for revenue-generating startups that want predictable, flexible repayments tied to performance rather than an equity stake (SBA.gov).

How each structure works (practical terms)

  • Convertible notes

  • Key terms: principal, interest rate (often modest, e.g., 2–8%), maturity date, discount (commonly 10–25%), and valuation cap. At conversion, the note converts to equity at the discounted price or at a price implied by the cap, whichever benefits the investor.

  • Outcomes: If there’s a priced equity round before maturity, conversion is automatic (per terms). If the company never raises a priced round, notes may be repaid at maturity or renegotiated. Notes are usually unsecured and subordinate to secured lenders.

  • Revenue-based financing (RBF)

  • Key terms: advance amount, revenue share percentage (often 2–10% of top-line revenue), and repayment cap (e.g., 1.5–3x the principal). Payments fluctuate with revenue—lower in slow months, higher in good months.

  • Outcomes: No equity is issued. Once the repayment cap is hit, the obligation ends. RBF providers commonly use a covenant tied to revenue reporting and may require personal guarantees or liens in some deals.

Real-world tradeoffs: founders’ perspective

  • Dilution vs. cash-flow flexibility

  • Convertible notes can convert into meaningful ownership for early investors in a successful follow-on round—this dilutes founders but aligns investor upside with eventual valuation.

  • RBF preserves equity, but the revenue share can constrain reinvestment during growth phases because a portion of gross revenue leaves the business regularly.

  • Speed and complexity

  • Convertible notes are familiar to many VCs and angels; standardized forms and precedents speed negotiation. See our deeper guide on convertible debt for common terms and legal risks: Convertible Debt for Startups: Pros, Cons, and Terms.

  • RBF deals often require stronger historical revenue data and cash-forecast transparency. For other alternative options tied to revenue, see: Alternative Financing for Startups: Revenue-Based and Merchant Cash Advances.

When one option usually fits better

  • Favor convertible notes when:

  • You expect a priced equity round within 12–24 months.

  • The business has high expected growth and eventual exit potential (VC-market fit).

  • You can accept some dilution to bring in strategic investors.

  • Favor RBF when:

  • You have consistent, predictable revenue (SaaS, subscription, recurring services, or steady retail).

  • Founder ownership is a priority and you want to avoid giving up equity.

  • Cash flow varies seasonally but you prefer payments that scale down in slow periods.

Risks and common mistakes

  • Ignoring conversion mechanics: founders sometimes set a valuation cap too low, creating excessive dilution at conversion. Negotiate caps and discounts with scenario modeling.
  • Overcommitting revenue: choosing an RBF revenue share that hampers growth (e.g., committing too large a percentage of gross revenue) can throttle reinvestment and hiring.
  • Assuming no lender protections: RBF providers may include covenants or revenue reporting rights; convertible note holders may demand pro rata rights or most-favored-nation provisions.

Practical tips from practice

In my work with early-stage companies, I recommend running 12–24 month cash-flow scenarios under both repayment/conversion outcomes. If you expect a quick priced round, model dilution vs. runway gained. If revenue is predictable, negotiate an RBF multiplier that matches your margin profile so payments don’t outpace profit.

Tax and legal notes (brief)

  • Interest on convertible notes is generally deductible to the company as interest expense when paid under U.S. tax rules; conversion is not a taxable event for the company but may affect investor basis. RBF payments are typically treated as loan repayments and finance costs—consult a tax advisor for specifics.

Further reading and internal resources

Authoritative sources

Professional disclaimer

This article is educational and does not constitute legal, tax, or investment advice. Your company’s best structure depends on specifics—consult a qualified attorney and tax professional before signing term sheets.