When To Use Convertible Notes In Business Funding

By - January 5, 2026 - Uncategorized

When your company is still in the early stages, securing funding can be a big challenge. While equity financing can be helpful later on, simpler and more flexible options may be a better fit during early fundraising. Take convertible notes, for example. Convertible notes can be a great way to bridge the gap between debt and equity and are often appealing to founders and investors alike. Let’s take a closer look at how convertible notes work and when to use them in business funding.

What Are Convertible Notes?

A convertible note starts as debt and later converts into equity. While this type of debt includes common debt features like a maturity rate, interest rate, and repayment obligations, unlike a traditional loan, repayment isn’t usually the goal. Instead, the principle and accrued interest eventually turn into ownership for the investor. This conversion typically occurs during the startup company’s next big round of fundraising.

Convertible notes offer flexibility, making them an appealing option for founders. Investors like them, too, because they help minimize risk while allowing them to gain equity at favorable terms.

When You’re Not Ready to Determine a Valuation

When your company is just starting out, it can be difficult to determine a valuation. You may think your concept is worth a lot of money, but an investor may not be easily convinced, especially if you don’t have much financial data to show. Since equity financing requires founders and investors to agree on a valuation, this isn’t always the easiest option for startup companies.

However, convertible notes provide a great alternative where neither side has to determine a valuation upfront. Instead, the investment starts as debt and converts into equity later at a priced round, at which point a valuation is set. This gives you, as the founder, access to financing while allowing investors to get involved without debating a valuation.

When You Want Fast and Efficient Financing

If moving quickly is a priority for your company, convertible notes can be a great choice, as they take less time to negotiate and close than equity deals. They also don’t typically involve the same level of investor due diligence, legal drafting, board approvals, and negotiations that are involved in an equity investment. Additionally, convertible notes often have fewer legal fees.

Convertible notes may be worth considering when:

• You need to act quickly to seize a market opportunity
• Capital is light, but waiting could put operations at risk
• You want to prioritize product development over time-consuming negotiations
• Several small investors are interested in making an investment at an early round

When time and resources are limited, convertible notes can help you quickly and efficiently raise capital.

When Using Convertible Notes Can Help Bridge Funding Gaps

Sometimes, you may need additional financing between rounds of fundraising. Convertible notes can help you bridge the gap so your startup can keep pushing forward.

This “bridge financing” can be helpful when:

• You need more capital before the next round of fundraising, but don’t want to do a full-priced round
• Unexpected delays or slower-than-expected revenue are at risk of impacting operations
• An investor needs more time to perform due diligence before they’re ready to get involved
• You happen upon an unexpected opportunity that requires immediate funding

When Investors Need Additional Incentives, Like a Conversion Discount

Early-stage investors take on more risk because they’re making an investment in a company that hasn’t yet proven to be viable. Convertible notes can be a great way to entice early investors by offering a conversion discount. This allows investors to convert their debt into equity at a percentage discount versus what future investors will pay at the next financing round. The discount is often 10% to 30%, which ultimately gives early investors more shares per dollar amount invested.

Planning for Future Debt Conversion

Interested in financing your startup via convertible debt? Since the main purpose of convertible notes is debt conversion, it’s important to understand the circumstances in which the debt can be converted into equity.

These circumstances usually include:

• Qualified financing: When a company raises its next major priced equity round, an automatic conversion is triggered when the amount raised surpasses a specific dollar amount.
• Maturity date: The date at which the startup owners and investors must address the outstanding debt. Options typically include converting the debt into equity, negotiating maturity terms, repaying the debt, or extending the note.
• Investor election: Investors are sometimes allowed to convert their notes early if the note approaches its maturity date without reaching the qualified amount.
• Sale or acquisition: If the startup is acquired before the note converts, the note is typically either repaid with interest or converted into sale proceeds.

Setting the Right Conversion Price

Conversion price is another key factor to consider when using convertible notes to fund your business. This is the price per share paid when the note is converted from debt into equity. In most cases, this price is based on the business valuation that’s negotiated during your next priced financing round.

There are a few different ways to determine the conversion price, such as:

• Based on valuation of the next round: Keep in mind that since early investors take on greater risk, they often get a discount on the price of conversion.
• Using a valuation cap: This is the maximum valuation at which the note will convert.
• Using hybrid structures: If preferred, you can use both a discount and a valuation cap when setting the price of conversion.

How Convertible Notes Compare to Equity Financing

Convertible notes and financing via equity have advantages and disadvantages. Convertible notes are often faster and cheaper to negotiate, and they offer downside protection and incentives to the investor. However, notes accrue interest and may have to be renegotiated if specific financing isn’t met by the maturity date.

Financing via equity, on the other hand, does not involve debt, and ownership is clear from the start. However, it can be more time-consuming and expensive to negotiate, and it requires investors and founders to agree on a valuation.

If speed, simplicity, and flexibility are your current priorities, it may be a good idea to start with convertible note financing.

Is a Convertible Note Right for Your Company?

The best way to determine if convertible notes are a good choice for your startup is to talk to an experienced business attorney. Attorney Drew Stevens of Stevens Law Firm can get to know your business and fundraising goals, explain how different financing terms can affect ownership, identify risks, and set up a structure designed to protect your long-term interests. Contact us today to learn more and schedule a free consultation.