Convertible Note Template: Structure and Key Terms

A convertible note template provides the standard structure and essential terms for startup debt financing that converts to equity in future funding rounds. These templates streamline early-stage investment agreements by establishing clear conversion mechanics, investor protections, and company obligations. Understanding the key components helps both founders and investors structure fair, legally sound financing agreements.

What is a Convertible Note Template

A convertible note template serves as a standardized framework for creating debt instruments that convert into equity at predetermined conditions. This document outlines all critical terms, conversion mechanics, and legal provisions needed to formalize short-term lending that transitions to ownership stakes.

Startup Financing Document

Convertible note templates function as the foundational agreement between startups and early investors. They document the principal investment amount, conversion terms, interest accrual, and repayment conditions. Templates typically range from 5 to 15 pages and include standard clauses from organizations like Y Combinator or the National Venture Capital Association.

Key Components:

• Principal amount and investment date
• Interest rate (typically 2-8% annually)
• Conversion discount (commonly 15-25%)
• Valuation cap provisions
• Maturity date (usually 18-24 months)
• Qualified financing threshold
• Investor rights and information provisions

Templates accelerate negotiation timelines by providing familiar structures that both parties understand. Investors can quickly evaluate terms against market standards, while founders avoid extensive legal drafting. Most templates require only 3-7 days to customize and execute, compared to 2-6 weeks for fully negotiated agreements.

Standard Template Sources

Debt-to-Equity Conversion Structure

The conversion structure defines exactly how and when debt transforms into equity ownership. This mechanism protects investors by offering discounted entry prices while giving startups flexible repayment alternatives.

Conversion Formula Components:

1. Principal Amount: Original investment sum
2. Accrued Interest: Time-based interest accumulation
3. Conversion Price: Lower of discount price or cap price
4. Conversion Shares: Total amount ÷ Conversion price

The conversion structure includes automatic and optional conversion triggers. Automatic conversion occurs when the company raises a qualified financing round (typically $1M-$2M minimum). Optional conversion allows investors to convert upon change of control events like acquisitions or IPOs.

Conversion Calculation Example

Scenario: $100,000 investment with 20% discount and $8M cap

Essential Convertible Note Terms

Every convertible note template includes specific financial terms that determine conversion economics and investor returns. These terms balance investor downside protection with startup operational flexibility.

Conversion Discount Rate

Conversion discounts typically range from 15% to 25%, with 20% being the market standard for seed-stage companies. This discount recognizes that note investors commit capital before valuation clarity and company de-risking through product development or customer traction.

Market Standard Discounts:

• Pre-product startups: 20-25%
• Revenue-generating startups: 15-20%
• Later-stage bridges: 10-15%

The discount applies only if it results in a lower per-share price than the valuation cap calculation. Investors automatically receive whichever mechanism yields more shares. This "dual benefit" structure protects investors whether the company raises at high or moderate valuations.

Discount Impact Analysis

$100,000 investment in $10M Series A at $1.00/share:

Valuation Cap

Valuation caps protect early investors from excessive dilution when startups experience rapid value appreciation. Common cap ranges are $5M-$10M for seed-stage companies and $10M-$20M for late-seed or bridge rounds. The cap establishes a "ceiling valuation" regardless of the actual next round valuation.

Cap Selection Factors:

• Company stage and traction
• Geographic market (Silicon Valley typically 20-30% higher)
• Investment amount and investor leverage
• Comparable recent seed rounds in sector

When the next round's valuation exceeds the cap, investors convert at the capped valuation, receiving substantially more equity than they would at the actual round price. This mechanism can result in note holders owning 2-5 times more equity than their investment percentage would suggest.

Valuation Cap Scenarios

$500,000 total notes with $8M cap:

Interest Rate and Maturity

Convertible notes accrue interest from the investment date, increasing the principal amount that converts to equity. Standard interest rates range from 2% to 8% annually, with 5% being most common. Interest typically compounds annually or at maturity.

Standard Maturity Periods:

• Seed-stage notes: 18-24 months
• Bridge rounds: 12-18 months
• Late-stage convertibles: 12 months

Most templates include automatic extension provisions if the company is actively fundraising at maturity. Extension periods typically add 6-12 months with sometimes higher interest rates (+2-3%) to compensate for extended timeline.

Interest Accumulation Example

$250,000 note at 5% annual interest:

Conversion Triggers and Events

Convertible notes specify exact conditions that trigger automatic or optional conversion from debt to equity. Understanding these mechanisms prevents confusion and ensures smooth execution during financing events.

Qualified Financing Round

Templates typically define qualified financing as raising $1M to $2M in a single round. This threshold ensures conversion occurs only for substantial institutional rounds, not small angel investments or bridge capital. The minimum amount prevents premature conversion at potentially unfavorable terms.

Qualified Round Criteria:

• Minimum gross proceeds (e.g., $1.5M)
• Issuance of preferred stock (not common)
• New money investment (not conversions of existing debt)
• Closing occurs before maturity date

Conversion occurs simultaneously with the qualified round closing. Note holders receive the same preferred stock series as new investors but at their discounted or capped conversion price. This means early investors get better economic terms while sharing the same rights and preferences.

Qualified Financing Conversion Process

Step-by-step execution:

1. Company announces Series A closing (2-4 weeks before close)
2. Note holders receive conversion notice (7-14 days before close)
3. Conversion calculations performed (1-3 days before close)
4. Notes convert at closing (simultaneous with round)
5. New stock certificates issued (1-5 days after close)

Change of Control Events

Change of control provisions address what happens when the company is acquired or undergoes ownership transition before raising a qualifying round. These clauses protect note holders from being locked into debt during exit scenarios.

Typical Change of Control Terms:

• Conversion option: Convert at cap or discount (investor choice)
• Repayment option: Principal + interest + premium (typically 1-3x)
• Acceleration: All accrued interest becomes due immediately

Some templates grant note holders first right to participate in acquisition proceeds on an as-converted basis. This means investors can choose to convert their notes and receive equity proceeds rather than debt repayment if the acquisition generates significant value.

Change of Control Scenarios

$200,000 note with $8M cap in acquisition:

Maturity Date Conversion

When notes reach maturity without a qualifying financing or change of control, templates specify several potential outcomes. Most agreements give the company three options: repayment, extension, or negotiated conversion.

Maturity Options:

• Shadow preferred: Convert at previously agreed valuation
• Common stock conversion: Convert at company valuation
• Repayment: Pay principal + interest in cash
• Extension: Extend maturity 6-12 months with modified terms

Many templates include automatic conversion provisions at maturity using either the valuation cap or a predetermined discount to the company's last 409A valuation. This prevents deadlock situations where the company cannot repay and investors resist conversion without clear pricing.

Maturity Resolution Pathways

Decision tree for $500,000 in notes at maturity:

Template Components and Sections

A complete convertible note template contains multiple sections covering financial terms, legal provisions, and procedural requirements. Understanding each component ensures proper customization and execution.

Principal Terms and Definitions

The opening sections establish all key financial terms and define specialized vocabulary used throughout the agreement. This foundation prevents misunderstandings about conversion mechanics, rights, and obligations.

Essential Defined Terms:

• Principal Amount: Initial investment sum
• Conversion Price: Price per share at conversion
• Maturity Date: Note expiration date
• Qualified Financing: Minimum round triggering conversion
• Company: The issuing startup entity
• Investor/Holder: The note purchaser
• Accrued Interest: Time-based interest accumulation

Principal terms sections also specify the note's payment mechanics, including interest rate, interest accrual frequency (typically annual), and payment method at maturity. These provisions establish the note as a debt instrument subject to standard commercial lending regulations.

Standard Template Sections

Investor Rights and Protections

Beyond conversion economics, templates grant investors specific rights and protections during the note period. These provisions ensure transparency and meaningful participation in major company decisions.

Standard Investor Rights:

• Information rights: Quarterly financial statements and annual audits
• Pro rata rights: Ability to participate in future rounds
• Major decision approval: Consent rights for acquisitions or significant changes
• MFN provisions: Automatically receive better terms if offered to later investors

Information rights typically last until conversion or repayment. They obligate the company to share monthly or quarterly management reports, annual audited financials, and material event notifications. Some templates include meeting attendance rights for significant investor groups.

Information Rights Comparison

Standard templates vary in disclosure requirements:

Company Obligations

Templates specify affirmative and negative covenants that restrict company actions and ensure investor protection during the note period. These obligations balance investor security with operational flexibility.

Affirmative Covenants (Required Actions):

• Maintain corporate existence and good standing
• Comply with all applicable laws and regulations
• Provide timely financial reporting
• Maintain adequate insurance coverage
• Preserve intellectual property protections

Negative Covenants (Prohibited Actions):

• No additional debt beyond specified limits
• No asset sales outside ordinary course of business
• No changes to capital structure without consent
• No dividends or distributions while notes outstanding
• No related-party transactions above specified thresholds

Most templates allow covenant violations to be cured within 30 days of written notice from investors. This grace period prevents technical defaults from causing catastrophic repayment demands over minor administrative oversights.

Covenant Violation Remedies

Typical template enforcement mechanisms:

1. Written notice of default (investor to company)
2. 30-day cure period (company fixes violation)
3. If uncured: Acceleration of maturity date
4. Repayment demand (principal + interest + premium)
5. Negotiated resolution (extension, conversion, or modified terms)

Customization Considerations

While templates provide standardized structures, most agreements require customization for specific company situations, industry contexts, or investment amounts. Strategic modifications ensure terms match the actual risk-reward profile.

Industry-Specific Modifications

Different industries require adjusted terms reflecting their unique capital intensity, development timelines, and risk profiles. Hardware startups often need longer maturity periods, while SaaS companies might accept shorter timelines due to faster revenue generation.

Industry-Specific Adjustments:

Industry modifications also affect covenant structures. Biotech companies typically have more lenient burn rate restrictions, recognizing high R&D costs. Hardware startups may include inventory-related provisions. Enterprise SaaS companies might add revenue milestone definitions.

Sector-Specific Provisions

Additional clauses by industry:

• Hardware: Inventory financing permissions, manufacturing partner approvals
• Biotech: Research milestone definitions, regulatory pathway requirements
• SaaS: Revenue recognition standards, customer concentration limits
• Fintech: Regulatory compliance provisions, licensing maintenance requirements

Investment Amount Variations

Note terms often scale with investment size. Larger investments typically command better terms (lower caps, higher discounts) while including more extensive investor rights and protections.

Term Scaling by Investment Size:

Large note investments may also include valuation adjustment mechanisms if the company significantly underperforms or overperforms projections. These provisions modify the cap or discount based on milestone achievement, aligning investor returns with actual company progress.

Negotiation Leverage Points

Factors affecting term negotiations:

1. Company traction: Revenue, users, product development stage
2. Market conditions: Hot vs. cold fundraising environment
3. Investor competition: Multiple term sheets improve founder leverage
4. Prior relationships: Previous investors often receive consistent terms
5. Syndicate dynamics: Lead investor sets terms, followers accept

Legal and Tax Implications

Convertible notes create specific legal obligations and tax consequences for both companies and investors. Understanding these implications prevents costly mistakes and ensures regulatory compliance.

Key Legal Considerations:

• Securities law compliance: Notes are securities requiring proper exemptions
• State blue sky laws: State-level securities regulations
• Accredited investor verification: Required for most exemptions
• Form D filing: Federal notice filing within 15 days
• Corporate authorization: Board and sometimes shareholder approval

Most convertible notes rely on Regulation D, Rule 506(b) or 506(c) exemptions from SEC registration. These exemptions limit offerings to accredited investors and require specific filing and disclosure procedures. Companies must maintain documentation proving compliance with all exemption requirements.

Tax Treatment for Investors:

• Interest income: Taxable as ordinary income when paid or accrued
• Conversion: Generally tax-free exchange of debt for equity
• Holding period: Begins at conversion date for capital gains purposes
• Loss treatment: Ordinary loss if company fails (Section 1244 potentially)

Tax Treatment for Companies:

• Interest expense: Tax-deductible as business expense
• Conversion: No taxable event when debt converts to equity
• Original issue discount: Complex rules if notes issued below par

Companies should obtain legal counsel review of all convertible note templates before execution. Legal fees typically range from $2,000 to $5,000 for template customization and review, a worthwhile investment to ensure proper structure and compliance.

Compliance Checklist

Pre-closing requirements:

• [ ] Board of Directors approval resolution
• [ ] Accredited investor verification completed
• [ ] Form D drafted and ready to file
• [ ] State notice filings identified
• [ ] Securities law exemption analysis completed
• [ ] Note terms reviewed by legal counsel
• [ ] Cap table impact modeled
• [ ] Integration with existing notes confirmed
• [ ] Investor rights coordinated with prior rounds

Post-closing requirements:

• [ ] Form D filed within 15 days
• [ ] State notice filings completed (varies by state)
• [ ] Notes executed and delivered to investors
• [ ] Funds received and deposited
• [ ] Cap table updated with note holders
• [ ] Corporate records updated
• [ ] Interest tracking system established
• [ ] Financial reporting obligations scheduled

Frequently Asked Questions

What is the difference between a convertible note template and a SAFE?

Convertible notes are debt instruments with interest rates and maturity dates that must be repaid if not converted, while SAFEs (Simple Agreements for Future Equity) are not debt, have no interest or maturity, and only convert to equity during future financing events. Convertible notes provide more investor protection through debt holder rights.

Can I use a free convertible note template for my startup?

Free templates from Y Combinator or NVCA work well for straightforward seed rounds but should be reviewed by legal counsel to ensure proper customization for your specific situation, state law compliance, and integration with any existing securities. Legal review costs $2,000-$5,000 but prevents costly mistakes.

What happens if my startup cannot repay the convertible note at maturity?

Most startups negotiate extensions (6-12 months), convert notes to equity at the valuation cap or a discounted 409A valuation, or restructure terms with investors. Fewer than 20% of startups can afford cash repayment, making conversion the most common maturity outcome.

How does a valuation cap differ from a pre-money valuation?

A valuation cap is a conversion mechanism that sets a maximum effective valuation for note conversion purposes, protecting investors from excessive dilution in high-valuation rounds. A pre-money valuation is the actual company value established in a priced equity round. The cap only matters if the actual valuation exceeds it.

Should I include both a discount and a valuation cap?

Yes, most seed-stage convertible notes include both mechanisms, with investors receiving whichever provides more shares at conversion. The discount protects investors in moderate-valuation rounds while the cap protects against very high-valuation rounds. This dual structure is market standard for notes over $100,000.

Do I need a lawyer to create a convertible note agreement?

While templates make DIY possible, legal counsel review is strongly recommended to ensure securities law compliance, proper state filings, appropriate term customization, and integration with your cap table and prior financing. Legal fees ($2,000-$5,000) are minimal compared to potential compliance or structural mistakes.