Convertible Notes — The Five Key Terms and How to Negotiate Them

A convertible note is a short-term debt instrument issued by a startup to investors, carrying an interest rate and a maturity date, with the right (and typically the obligation) to convert into equity at a future financing event. Unlike a SAFE, it sits on the balance sheet as a liability until conversion. Its five key terms — valuation cap, discount rate, interest rate, maturity date, and qualified financing threshold — each require careful negotiation.

How a Convertible Note Works

When a startup issues a convertible note, the investor lends the company money (the principal). Until conversion, the note accrues interest, typically simple interest (not compounded). When a qualifying financing event occurs — usually a priced equity round above a specified threshold — the principal plus accrued interest automatically converts to the new class of preferred stock, at a discount to the round price or at the cap price, whichever is more favorable to the investor.

If no qualifying financing occurs before the maturity date, three scenarios are possible: the company repays the note in cash, the note is extended by mutual agreement, or the parties negotiate a conversion on modified terms. As one founder-side VC noted: "No one wants the notes to ever get paid. The investors are not seeking interest — the goal is conversion into a priced round."

The Five Key Terms

1. Valuation Cap

Same concept as in a SAFE: the maximum valuation at which the note converts, protecting the investor if the company raises at a much higher valuation. The cap rewards early risk-taking. Current benchmarks: pre-seed caps $5M–$15M; seed stage caps $12M–$30M.

2. Discount Rate

A percentage reduction on the Series A price per share. Typical market standard: 20%, ranging from 10%–30% depending on stage and risk. The investor pays 80 cents for every dollar Series A investors pay.

3. Interest Rate

Unlike traditional loans, convertible note interest is typically not paid in cash — it accrues and converts to additional equity at conversion. Current market rates: 5–10% annually, with 6–8% most common. In a higher-interest-rate environment (SOFR at 4.5%+ in 2024–2025), note rates have trended up from the historical 4–6% range.

4. Maturity Date

The date by which the note must either convert or be repaid. Typical range: 18–36 months. The maturity date creates a deadline that can become a negotiating lever for investors if the company hasn't raised a qualifying round in time — they may demand a lower cap, higher discount, or equity stake in exchange for an extension. Three scenarios at maturity:

• Cash repayment — rare; most companies cannot repay without a new financing
• Maturity extension — mutual agreement to extend, often with improved investor terms
• Conversion to equity — mandatory conversion into common or preferred stock at a negotiated price

5. Qualified Financing Threshold

The minimum size of a priced financing that triggers automatic conversion. Typically set at $1M–$5M. This threshold matters: if the company closes a small bridge round that doesn't meet the threshold, the note continues as debt rather than converting — which may not be what either party wants.

When to Use a Convertible Note vs. a SAFE

Negotiation Tactics

From the founder's perspective, the most important leverage points:

• Cap level: Anchor to the highest justifiable number. The cap becomes the ceiling on early investor ownership — a lower cap means more dilution for founders at conversion.
• Maturity date: Push for 24–36 months. 12-month maturities create unnecessary pressure to close a priced round.
• Interest rate: Often underfocused. Model the accrued interest at 12 and 18 months before accepting the rate.
• Competing term sheets: Having multiple term sheets creates negotiating leverage on all five terms. Accept the first offer only when you have no alternative.
• Maturity conversion terms: Negotiate upfront what happens at maturity if no qualified financing has occurred — automatic conversion to equity prevents the standoff scenario.

Accounting Treatment Under ASC 470 and ASU 2020-06

The accounting for convertible notes changed significantly with ASU 2020-06 (effective for public companies in 2022). Under the new standard, most convertible instruments are accounted for as a single unit — the issuer no longer needs to separately account for the debt and equity components (bifurcation) unless the conversion feature meets specific criteria. For pre-IPO companies:

• Single-unit approach: The convertible note is recorded as a single liability at its face value; no equity component is separately recognized. This eliminates the "beneficial conversion feature" (BCF) accounting that previously created large, non-cash interest charges on deeply discounted notes.
• Debt issuance costs: Financing costs (legal fees, bank fees) paid to issue the convertible note are recorded as a contra-liability (reducing the carrying value of the note) and amortized to interest expense using the effective interest method over the note's expected term.
• Interest accretion: If the convertible note has an interest rate below market (common for converts with conversion discounts), the effective interest rate is higher than the stated rate — and the difference accretes as additional interest expense.

Sizing and Terms — Market Practice

For pre-IPO growth companies, convertible note terms have standardized significantly since 2015. Current market practice:

Convertible Notes in Practice

Airbnb — $2 Billion Convertible Notes Before the 2020 IPO

In April 2020, alongside its SAFE-like warrant instruments, Airbnb also raised $1 billion in term loans and convertible notes from Silver Lake and Sixth Street Partners. The convertible notes carried an interest rate of 7.5% and were convertible into equity at a 20% discount to the eventual IPO price, subject to a cap. The notes also included warrants giving the holders the right to purchase additional Airbnb shares. When Airbnb IPO'd at $68 per share in December 2020, the convertible note holders received equity at approximately $54.40 per share (20% discount) — a significant gain relative to their investment thesis in April 2020 when many observers questioned whether Airbnb would survive the pandemic. The Airbnb 2020 convertible note is a textbook example of convertible instrument economics working as intended: the investors took meaningful risk by providing capital at Airbnb's darkest moment, and the conversion discount rewarded them appropriately.

Uber — Complex Convertible Portfolio Before the 2019 IPO

Uber's May 2019 IPO required reconciling a complex portfolio of outstanding convertible notes, warrants, and preferred stock from multiple financing rounds spanning 10 years of private market capital raising. The company had issued convertible notes to various investors over the years, with different caps, discounts, and maturity dates. The ASC 470 accounting for these instruments required careful documentation of each instrument's classification (debt vs. equity) and the applicable conversion mechanics at IPO. Uber's S-1 dedicated an unusually detailed section of the footnotes to the description of its outstanding convertible and debt instruments, reflecting both the complexity of the capital structure and the SEC's expectation of full disclosure. The lesson for pre-IPO companies: every convertible note, SAFE, and warrant issued during the private years creates an accounting and legal disclosure obligation at IPO — maintain meticulous records from the first instrument issued.

Primary Sources

Current Market Benchmarks (2024–2025)

Based on Carta and NVCA data for US seed and pre-seed financings in 2024–2025:

Managing Multiple Convertible Note Tranches

Companies that raise multiple convertible note tranches over time create complexity at conversion. Each tranche may have different caps, discount rates, and interest accrual periods — all of which must be tracked and modeled separately when the priced round arrives. Common issues:

• Different conversion prices per tranche: If the Series A price is $2.50/share and one note has a $10M cap (converting at $1.40/share) while another has a $15M cap (converting at $2.10/share), each tranche converts at a different price — the cap table becomes complex quickly
• Accrued interest tracking: Notes issued at different times have accrued different amounts of interest. Each investor's conversion value is principal plus accrued interest as of the conversion date — not just principal.
• Most favored nation complications: If any note has an MFN provision and subsequent notes were issued at better terms, the MFN holder has the right to adopt those terms — this can create a retroactive cap adjustment that must be calculated before conversion

Tax Considerations for Convertible Note Holders

For investors, the tax treatment of a convertible note depends on how it ultimately converts:

• Interest accrual: Interest accrued on a convertible note is generally taxable to the investor as ordinary income in the year it accrues — even if it has not been paid in cash. The company should report accrued interest on Form 1099-INT (or equivalent).
• Conversion to equity: When the note converts to preferred stock, the conversion itself is generally not a taxable event — no gain or loss is recognized at the time of conversion. The investor's basis in the preferred stock equals the principal plus accrued interest paid.
• QSBS eligibility: The holding period for QSBS purposes generally begins at conversion to equity, not at note issuance. If the note was issued while the company still qualified as a QSBS company and converts before the company loses QSBS status, the shares may be eligible for the Section 1202 exclusion after a 5-year holding period.