This glossary term discusses the convertible notes used in the context of startup finance, which should not be confused with the convertible bonds that are sometimes issued by reporting companies or other more established businesses. For information about those convertible securities, see Practice Note, Convertible Bonds: Overview.

In the startup finance context, convertible notes are debt securities issued by startup companies to raise capital from investors. These investors generally expect their notes to convert into the companies' equity securities in the future instead of receiving the return of their principal plus interest. Also known as convertible promissory notes, bridge notes, or convertible debt. Since convertible notes are securities, they must be registered, or qualify for an exemption from registration, under the Securities Act. For information on securities law considerations, see Practice Note, Section 4(a)(2) and Regulation D Private Placements.

Convertible notes are the most frequently used instrument for raising modest amounts of capital at a startup's seed round of financing. They are debt securities that have the following key terms:

Although formally a debt instrument, many investors view convertible notes as deferred or unpriced equity in substance. The goal of their investment in the notes is to convert them into the same preferred equity security the company issues to its first institutional venture capital (VC) investor in the company's Series A round, rather than to receive their principal plus interest at maturity. Therefore, investors typically view the conversion features of the notes as the most important provisions in a convertible note deal, as they are the mechanisms by which the noteholders eventually become stockholders of the company.

Convertible notes give their holders the right to receive equity of the company on certain triggering events, such as:

The price of the equity that the noteholders receive on conversion is lower than the price of the securities issued to VC investors in connection with a Next Equity Financing, based on either a:

More developed startups also use convertible notes as bridge financing to a later-stage equity round or a sale of the company. For this reason, convertible notes are sometimes referred to as bridge notes (see Practice Note, Startup Venture Finance: Overview: Bridge Financings).

For more information on convertible notes for seed-stage startups, see Practice Note, Startup Seed Financings: Overview.