Convertible Note Agreement: Flexible Funding for Startups

Introduction

When your startup needs funding fast but isn’t ready to set a valuation, a convertible note agreement can be the ideal solution. It lets investors provide capital now, with repayment coming in the form of equity later — usually at your next funding round.

But like any financing tool, convertible notes have their advantages, drawbacks, and traps. Understanding them is essential to raising funds without creating future headaches.

Related reads: See SAFE Agreement for an alternative early-stage funding option, and Cap Table Management to understand how convertible notes affect ownership.

What Is a Convertible Note Agreement?

A convertible note agreement is a debt instrument that allows an investor to loan money to a startup, with the debt converting into equity at a later date — typically during the next priced equity round.

This structure avoids the need to determine a company valuation at the time of investment, which can be tricky for early-stage businesses.

Convertible notes generally include:

◼️Principal amount – The investment sum

◼️Interest rate – Accrued until conversion or repayment

◼️Maturity date – When the note must convert or be repaid

◼️Conversion terms – Conditions under which debt converts to equity

Quick PAA Answer:
 Q: Is a convertible note debt or equity?
 A: Initially, it’s debt. Upon a triggering event, it converts into equity.

Why a Convertible Note Agreement Matters for Startups

For many startups, a convertible note agreement offers:

◼️Speed and Simplicity

No lengthy valuation negotiations early on.

Related read: SAFE Agreement for an even simpler alternative.

◼️Flexibility in Structuring

Can include discounts, valuation caps, and other investor incentives.

◼️Investor Appeal

Investors get downside protection (as debt) and upside potential (as equity).

◼️Cost-Effective Fundraising

Less legal complexity than a full equity round.

Key Terms in a Convertible Note Agreement

When drafting your convertible note agreement, watch for:

◼️Valuation Cap

The maximum valuation at which the note will convert into equity.

Investor protection against excessive dilution.

◼️Conversion Discount

A percentage discount on the price per share in the next round.

◼️Interest Rate

Can be paid in cash or added to the principal upon conversion.

◼️Maturity Date

If the startup doesn’t raise a qualifying round by this date, the investor can demand repayment or conversion.

◼️Qualified Financing Definition

Specifies the minimum size and terms of the next funding round to trigger conversion.

◼️Repayment Terms

What happens if no conversion event occurs — repayment in cash or equity?

Risks of Using a Convertible Note Agreement

Without careful drafting, you could face:

◼️Unexpected dilution if valuation caps or discounts are too aggressive.

◼️Repayment demands if you can’t trigger a conversion event by maturity.

◼️Investor disputes over conversion triggers or definitions.

◼️Cap table complexity if multiple notes are issued with different terms.

Quick PAA Answer:
 Q: What happens if a convertible note matures before the next funding round?
 A: The investor may demand repayment or renegotiate terms for conversion.

Case Study: Avoiding a Downside Surprise

A startup raised $500k via convertible notes with a valuation cap of $3M.

When the Series A round was priced at $10M, the early investors converted at the $3M cap, giving them a much larger equity stake than the founders anticipated.

The founders hadn’t fully understood the dilution impact — a detailed discussion with legal counsel before signing could have set terms that balanced investor incentives with founder protection.

Frequently Asked Questions

Q: Convertible note vs SAFE — which is better?
 A: SAFEs are simpler and don’t accrue interest, but notes offer more traditional debt protections for investors.

Q: Can convertible notes be used in all jurisdictions?
 A: No — some countries have restrictions on convertible debt for private companies.

Q: Do convertible notes always convert?
 A: Not necessarily — they may be repaid instead, depending on the terms.

Q: Are convertible notes good for pre-revenue startups?
 A: Yes, they’re often used when valuation is too hard to determine early.

How GLS Can Help

GLS provides practical, investor-ready funding documentation:

◼️Drafting customised convertible note agreements

◼️Reviewing investor-provided notes for founder risks

◼️Advising on valuation caps and discount structures

◼️Integrating notes into your cap table planning

◼️Negotiating with investors for balanced terms

◼️Structuring multiple notes for consistency

◼️Preparing for SAFE vs note decision-making

◼️Cross-border convertible note advice

◼️Fast turnaround for urgent funding rounds

◼️Fixed-fee legal packages for startups

Useful GLS Resources

GLS Startup Legal Packages

GLS SAFE Agreement Guide

GLS Cap Table Management Guide

Conclusion

A convertible note agreement can be a fast, flexible way to raise funds — but it’s not risk-free. Understand the terms, plan for the dilution impact, and ensure your cap table can handle the conversion before signing anything.