Convertible notes are loans that will convert into equity "triggered" by an event, e.g. another funding round. If no such event occurs, the debt is repaid at the maturity date set in the agreement unless the terms of the note allow for equity conversion at a discounted price at its maturity. If the convertible notes accumulate interest, the interest is also converted into equity.
Convertible notes operate on terms that are advantageous for both the investor and the startup:
For the investor, the advantage of convertible notes is the valuation cap or discount rate that applies during the conversion. The valuation cap is settled at the conversion time, and it will not increase during future rounds. Consequently, if the company's valuation has increased beyond the valuation cap of the note, the latter will convert into equity at the predetermined valuation price.
For the startup, it is a quick way of accessing capital at an early stage, removing the lengthy process of creating and issuing common stock. In addition, it allows them to postpone their valuation calculations to a later stage when improved financial performance allows for a more accurate valuation.