How conversion usually works
A convertible note is a loan that is expected to convert into equity, usually at a later priced financing round. Investors typically receive a benefit for coming in early through a discount on the future price, a valuation cap, or both, and the interaction between those terms can significantly change how much of the company each noteholder ends up owning. The agreement should say what counts as a qualifying financing, what happens if the company is sold before conversion, and whether conversion is automatic or optional. Founders often focus on the cap and overlook the rest. Modeling a few scenarios against your cap table before signing is worth the time.
Maturity, interest, and legal formalities
Because a note is debt, it carries an interest rate and a maturity date, and if no financing happens by then the parties have to decide whether to extend, convert, or repay. Noteholders sometimes have leverage at that moment that founders did not anticipate. A note is also generally a security, so the offering needs an exemption from registration, often under Regulation D, along with any required federal and state notice filings. New York usury law has been applied to some convertible notes, and courts have considered the conversion feature when testing whether the rate is excessive, which matters especially for notes with steep discounts. Some startups use a SAFE instead, which is not a loan and has no maturity date, but brings its own questions.
Reviewing the agreement before signing
In a first review we look at the note's economics, the conversion triggers, the treatment of a sale, maturity terms, and any side letters giving particular investors extra rights. We ask how many notes you expect to issue and whether they should be on identical terms, since inconsistent notes complicate the eventual round. Investors reviewing a convertible note agreement often look at whether the company can amend the notes with consent of a majority of holders and whether they are protected against later notes on better terms. We also check board approval and how the notes will appear on the company's records. Clean documents make the next financing easier for everyone.
