Convertible Note
An early-stage debt instrument that converts to equity at the next funding round. Carries interest and a maturity date. Used when valuation is uncertain; typically paired with a cap and discount rate.
Convertible Note is a debt instrument that converts to equity at a future funding round rather than being repaid at maturity in cash. The investor lends money to the startup, which accrues interest at an agreed rate. When the startup raises a qualifying priced equity round, the note — principal plus accrued interest — automatically converts to equity shares at a price determined by the conversion terms.
Convertible notes are used at pre-seed and seed stage when agreeing on a company valuation is difficult. Rather than negotiate a valuation now, the instrument defers that question to the next institutional round, where pricing is established by a lead investor.
Who it applies to
- Startups raising early-stage capital from angel investors, HNIs, or early-stage funds before a priced equity round
- Investors who want to deploy capital quickly without negotiating a full shareholder agreement and valuation
- Bridge financing — existing investors extending capital to keep a startup funded until the next round closes
Conversion mechanics
Two standard terms define how the note converts:
Valuation cap: The maximum valuation at which the note converts. If the Series A values the company at ₹50 crore but the cap is ₹20 crore, the note converts as if the valuation were ₹20 crore — the note holder receives more shares than Series A investors for the same rupees invested.
Discount rate: The note converts at a percentage below the Series A price per share. A 20% discount means the note holder pays 80% of whatever the Series A price turns out to be.
Notes often carry both a cap and a discount; the investor uses whichever conversion is more favourable.
| Conversion term | Effect |
|---|---|
| Valuation cap | More shares if the round prices company above cap |
| Discount rate | Lower per-share cost relative to new investors |
| Most favoured | Investor gets the better of cap or discount |
What most founders miss
Convertible notes are debt — they must be repaid if conversion does not happen. If the company does not raise a qualifying round before maturity (typically 12–24 months), the note holder can demand repayment. A startup that takes convertible note funding and then cannot raise a priced round faces debt obligations at the worst possible time.
Interest accrues and converts, increasing the note holder's equity. A ₹50 lakh note at 12% per annum for 18 months becomes ₹59 lakh of principal-plus-interest that converts at the next round. The interest is not paid in cash — it converts alongside the principal — but it increases the equity the note holder receives relative to the headline investment amount.
The regulatory framework for domestic convertible notes is unsettled. Most Indian VC-backed seed rounds use CCPS or ordinary equity rather than convertible notes, because the Companies Act framework for convertible notes issued to domestic investors is less clear than the FEMA framework for foreign investors. Startups that want to issue convertible notes domestically should structure carefully with a CA to avoid inadvertent deposits or securities law violations.
See also
- CCPS (Compulsorily Convertible Preference Shares) — the standard priced equity instrument for Series A and beyond
- FEMA (Foreign Exchange Management Act) — governs convertible notes issued to foreign investors; DPIIT recognition enables the five-year conversion window
- Angel Tax — abolished from 1 April 2024; previously created uncertainty on note conversions where shares were issued above FMV
- DPIIT Recognition — required for the RBI-recognised convertible note framework for foreign investors
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