Anatomy of Seed Stage Convertible Notes by Bettina Eckerle

Anatomy of Seed Stage Convertible Notes

As I outlined in my last post, convertible notes are the most frequently used instrument for raising capital at the seed stage. This article describes their key features.


Convertible notes have an annual interest rate, which has recently ranged from 4–8%. The interest is either added to the principal balance when a note converts into equity or is paid in cash at the time of conversion or repayment.

Investors usually don’t – and they shouldn’t – pay too much attention to negotiating the interest rate, as the key economic feature is the valuation discount and cap. Accrued interest is really the side show in how investors participate in the upside of a business. I explain in more detail below.


Most convertible notes mature between 12 and 24 months. There are two ways of dealing with maturity: Either each note becomes due and payable on demand by each individual noteholder, or the series of notes becomes payable when the majority of the principal of that series demands it. I advise clients to use the latter, as it leaves the decision to demand repayment with the largest noteholders. It is always easier to negotiate with one, hopefully more sophisticated, constituent than with a myriad of smaller investors on a one-on-one basis.

Priority and Security

Convertible notes issued in seed financings are almost always general unsecured obligations of the company. This means the noteholders have a claim on the company’s assets that is senior to all equity holders and typically pari passu with all other unsecured non-senior debtholders.

Conversion Events

Convertible notes convert into equity on the occurrence of:

  • The closing of a next equity financing (Series A);
  • The sale of the company;
  • Maturity.

Series A Conversion

In a Series A conversion, the principal and interest of each note converts into the same shares of stock that a new equity investor purchases in the subsequent financing round, however, at a discounted conversion price (which I discuss below).

Typically the financing has to be a minimum size (often $1 million) to automatically trigger the conversion. Sometimes, the threshold includes the aggregate principal amount from the note financing, which makes it less meaningful for the investors (particularly, if the company raises over $500,000 in convertible debt, as is often the case).

Sale Conversion

If the company is sold while the notes are still outstanding, investors may elect to either:

  • Receive the principal and accrued interest (or sometimes the interest plus some multiple of the principal) of their notes; or
  • Convert the value of their notes into shares of common stock at a discount to the price at which the acquirer has offered, or at the price calculated by the valuation cap.

Some convertible note documents also provide for conversion in the event of an IPO.

Maturity Conversion

If the notes mature before a Series A conversion or a sale of the company occurs, noteholders typically have the option to:

  • Convert their notes into shares of common stock;
  • Demand repayment; or
  • Leave the notes outstanding.

I personally have never seen investors converting their notes to common stock. Continuing to hold debt of the company with the possibility of receiving preferred stock in a Series A is generally seen as the more attractive option compared to holding common stock alongside the founders, for obvious reasons.

Conversion Price

Readers, pay attention. I have been driving this home, but this is the key feature in every convertible debt instrument. Investors and founders alike should really spend most of their time and attention on the conversion price to determine the extent to which investors participate in the upside of the business. When a conversion event occurs, noteholders receive equity based on the principal and interest balance of their notes, but at a price that is lower than the price paid by the Series A investors. The lower price is calculated based on one of the following:

  • A discount rate; or
  • A valuation cap.


When notes convert at the Series A stage, the price per share used to calculate the note conversion is less than the price per share of the preferred stock that the company issues to the new equity investors. The rationale is that early stage investors should get rewarded for the greater risk they are taking compared to later investors, which makes sense.

Discounts in seed financings typically range between 10–30%, and the most common is 20%. Sometimes discounts are structured to step up based on how long the notes have been outstanding.

Valuation Cap

Most convertible notes also contain a cap on the pre-money valuation at which the notes may convert in a Series A. The rationale for including a cap is to prevent an outcome where noteholders get reduced to a de minimis ownership percentage, where the note financing was smallish and there is an unusually high valuation in a Series A round.

When notes contain a discount and a valuation cap, the notes convert at the lesser of the price calculated based on the discount or the cap.

Currently, valuation caps range between $3–5 million on the lower end and $8–10 million on the higher end.

This is really it. The rest is boilerplate (not to belittle it). That’s why convertible notes are cost-efficient (really low legal fees) and quickly executed. The documentation usually consists of a note purchase agreement and the note itself. For an outline of SAFES, stay tuned.

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