A convertible note is a short-term debt instrument that converts into equity, typically shares in a company, when the startup completes a qualifying funding round. Rather than negotiating a company valuation upfront, the investor lends money and receives shares later, usually at a discount to what other investors pay. It's one of the most widely used early-stage funding tools in Australia's startup ecosystem, and the terms buried in the document shape who wins and who loses when the conversion eventually happens.
How a convertible note actually works
At its simplest, a convertible note starts as a loan. An investor hands over, say, $100,000 to a pre-revenue startup. Instead of setting a repayment schedule, both parties agree that the money will convert into shares when a future funding round is closed, typically a Series A or a priced seed round. The investor doesn't get repaid in cash. They get equity.
The conversion doesn't happen at par. Two key mechanisms protect the early investor for taking on the risk of backing an unproven company. The first is the discount rate, which gives the investor shares at a percentage below the price paid by the later investors. A 20% discount is common. If Series A investors pay $1.00 per share, the convertible noteholder converts at $0.80.
The second mechanism is the valuation cap. This sets the maximum valuation at which the note can convert, regardless of how high the next round is priced. If the cap is $5 million and the Series A values the company at $10 million, the note converts as if the company were worth $5 million. That produces far more shares for the early investor.
When both a discount and a cap exist, the investor typically gets whichever calculation is more favourable to them.
The key terms to understand
Beyond the discount and the cap, three other terms appear in almost every convertible note.
- Interest rate. Convertible notes are technically loans, so they accrue interest, often between 5% and 8% per year. That interest usually converts into shares alongside the principal, meaning the investor gets a slightly larger equity stake at conversion.
- Maturity date. This is the date by which a qualifying round must occur. If no round closes before maturity, the noteholder can either demand repayment in cash or negotiate an extension. That creates real pressure on founders to close a round on time.
- Conversion trigger. Not every round triggers conversion automatically. A qualifying round is usually defined as a priced equity round above a minimum threshold, often $500,000 or $1 million raised. Smaller rounds may not trigger conversion at all.
Why founders prefer convertible notes over priced rounds
Valuing a startup early is genuinely hard. There's no revenue, no customer base, and often no product. A priced equity round requires agreeing on a number, and both sides usually feel they got the worse end. Convertible notes sidestep that problem entirely. Founders issue the note quickly, take the cash, and defer the valuation conversation until the company has more evidence to support a stronger number.
Legal costs are lower too. A term sheet for a priced round can generate weeks of negotiation and tens of thousands of dollars in legal fees. A convertible note can be documented in a few pages and closed in days. For an early-stage company burning through cash, speed is worth something.
Why investors accept the uncertainty
From the investor's side, the discount and valuation cap compensate for the risk of converting into an unknown future structure. An angel investing $100,000 at a $4 million cap into a company that later raises at a $20 million valuation will receive shares at a dramatically better price per share than Series A investors. That upside is the trade-off for investing blind, before the market has set a price.
Institutional investors approach convertible notes differently. Venture capital funds, which you can read more about in our guide to venture capital and how it works, often prefer priced rounds because they have governance requirements and fund mandates that don't mesh well with deferred valuations. Convertible notes are more common with angel investors, high-net-worth individuals, and early-stage family offices.
Risks for founders
Convertible notes carry real danger if a qualifying round doesn't materialise. At maturity, a noteholder can demand repayment in cash. A startup that has spent the capital and hasn't raised a priced round faces an impossible position. Most notes get extended by mutual agreement, but that requires goodwill on the investor's side and often comes with renegotiated terms that are less favourable to the founder.
Cap table complexity is another issue. Multiple convertible notes with different caps and discount rates can produce messy, unpredictable outcomes at conversion. A Series A investor looking at a company's ownership structure wants clarity. Too many notes with conflicting terms can slow or kill a deal. Founders who issue convertible notes too freely sometimes find their cap table is a problem when they finally try to raise a proper priced round.
How a convertible note compares to a SAFE
The Simple Agreement for Future Equity (SAFE), developed by Y Combinator, is the other dominant early-stage instrument. A SAFE isn't a loan. It has no interest rate, no maturity date, and no debt component. It converts into equity on the same triggers as a convertible note but without the repayment risk hanging over the company.
In Australia, SAFEs are less common than in Silicon Valley, though they're gaining ground. Many Australian investors still prefer the debt framing of a convertible note because it provides a clearer legal position if the company fails. The shareholders' agreement that follows a priced round supersedes most of the mechanics in either instrument, but how you get to that round depends heavily on which structure you chose at the start.
A practical example
An investor puts $150,000 into an early-stage Melbourne software company via a convertible note. The note has a $4 million valuation cap, a 20% discount, and an 8% annual interest rate. Twelve months later, the company raises a $2 million Series A at a $10 million pre-money valuation, pricing shares at $1.00 each.
The investor's $150,000 has grown to approximately $162,000 with interest. Under the cap calculation, the effective price per share is $0.40 (the $4 million cap divided by the same share count used for the $10 million valuation). Under the discount, the price would be $0.80. The cap wins. The investor receives roughly 405,000 shares, compared to the 162,000 they'd have received if they'd invested at the same price as Series A. That difference is the reward for taking the early risk.
For any founder or investor operating in Australia's startup market, understanding convertible notes isn't optional. The mechanics are straightforward once you see them in context, but the details buried in the cap and maturity date determine whether the instrument works in your favour or against it.