A convertible note is a debt or loan. This debt has a principal amount (the amount investor gives to the startup), an interest rate, and a maturity date (when the principal + interest needs to be paid back).

How is it different? It is convertible that is the debt converts into equity. Let’s say you’re raising your seed round via convertible note. In your next equity financing (in this case Series A) round, the debt will convert to shares of preferred stock. The benefit is that the investor will pay a lower price per share as compared to other investors in the equity financing round. The conversion typically involves some sort of discount on the price of the stock or the valuation in the future round.

For example, let us assume that you raise $500k in convertible debt from some investor with a 20% discount in the next round. After a year, when you raise your Series A funding with some VC at let’s say $1 per share. So in this case the owner of the convertible note will get 625k Series A shares (at $ 0.8 per share) - a 1.25x return excluding the interest on the loan.

The discount generally ranges from 10% to 35% and the most common being 20%.

The other variation is with a “cap”. A cap is a maximum valuation that the investor/debt owner will pay, irrespective of the valuation of the round in which the conversion happens. We will cover this is in the next post.