Guide

Convertible notes and startup seed financing explained

Harbor Analytics closed a $2.1 million seed bridge on three convertible notes in January 2024: 6% simple interest, 18-month maturity, $14 million valuation cap, 20% discount, and a $1.5 million minimum qualified financing trigger. Product-market fit arrived on schedule, but enterprise sales cycles stretched the Series A close to month 23. Two noteholders demanded repayment at maturity; the third agreed to a six-month extension at 8% PIK (payment-in-kind) interest. The eventual $22 million post-money Series A priced at $18 million pre-money — above the cap — but founders modeled conversion on principal only and missed $127,000 of accrued interest converting into an extra 0.9% dilution. Legal fees for the extension and side-letter renegotiation added $34,000. The CFO’s takeaway: notes are debt with a clock, not “SAFEs with interest sprinkled on.”

A convertible note is short-term debt that converts into equity at a future priced round (or another trigger event) instead of repaying cash at maturity. It was the default seed instrument before Y Combinator popularized SAFEs. Notes still appear in bridge rounds, international markets, and deals where investors want contractual maturity, interest compensation, and seniority in a wind-down. This guide covers note mechanics, cap and discount conversion math, maturity and extension paths, stacking multiple notes, the Harbor Analytics cap-table walkthrough, a financing-instrument decision table, pitfalls, and a founder checklist before you sign.

What a convertible note is (and how it differs from a SAFE)

Structurally, a convertible note is a loan: the company owes principal, typically accrues interest, and faces a legal maturity date. Conversion is the hoped-for exit — at a qualified equity financing (priced round above a threshold), the note balance (principal plus accrued interest) converts into preferred shares at a price determined by the cap, discount, or round price, whichever is most favorable to the investor.

Unlike a SAFE, a note creates a balance-sheet liability. If the company fails to raise before maturity and cannot extend, holders can demand repayment — a real problem for cash-burning startups. In bankruptcy or asset sale, noteholders generally rank ahead of common shareholders (though behind secured creditors). SAFE holders sit with common in many wind-downs and have no maturity sword.

Public-market convertible bonds share the conversion concept but trade on exchanges with bond-floor pricing; startup notes are private, illiquid, and negotiated per deal.

Standard term sheet components

Principal and interest

Principal is the cash wired at closing. Interest accrues as simple or compound, usually 4–8% annually for seed notes. Interest almost always converts with principal rather than paying out in cash pre-exit. PIK interest capitalizes into principal each period, compounding dilution at conversion.

Maturity date

Typical maturities run 18–24 months from signing. At maturity, if no qualified financing occurred, outcomes include: (1) automatic extension if holders agree; (2) mandatory conversion at the cap (if the note allows); (3) repayment demand; (4) note amendment with worse economics (higher cap, extra warrants). Founders often underestimate how many notes mature before the next priced round closes.

Valuation cap and discount

The valuation cap sets a maximum effective pre-money valuation for conversion. The discount (often 15–25%) gives a lower price per share than the new investors pay. Conversion uses the better (lower) price for the noteholder — not both stacked. If Series A prices at $20M pre and the cap is $14M with a 20% discount, the cap wins because $14M is lower than $20M × 0.80 = $16M.

Qualified financing threshold

Notes convert only when a priced round raises at least a stated minimum (e.g. $1–3 million). A $500k friends-and-family round may not trigger conversion, leaving notes outstanding and ticking toward maturity.

Other common clauses

Most-favored-nation (MFN) lets a later noteholder inherit better terms from an earlier note. Pro-rata rights let investors buy their ownership share in the Series A. Change-of-control provisions may force conversion or repayment at 1–2× principal. Warrants on notes are rare at seed but appear in distressed extensions.

Conversion math at Series A

Assume Harbor Analytics raises Series A at $18M pre-money, $22M post-money, issuing new preferred at $1.80/share. One note: $700,000 principal, 6% simple interest, 22 months accrued = $77,000 interest. Total converting balance: $777,000.

Cap price: $14M pre ÷ fully diluted shares pre-round. If 10M shares outstanding pre-Series A, cap price = $1.40/share. Discount price: $1.80 × 0.80 = $1.44/share. Cap wins at $1.40. Shares issued to noteholder: $777,000 ÷ $1.40 ≈ 555,000 shares.

If founders had ignored interest, they would have modeled 500,000 shares ($700k ÷ $1.40) — understating dilution by 55,000 shares (~0.5% on a fully diluted base of ~11.7M post-round). Multiple notes compound the error.

Post-conversion, noteholders hold preferred stock subject to the same liquidation preference and anti-dilution terms negotiated in the Series A — unless the note side letter carved out exceptions (unusual at seed).

Maturity paths when Series A slips

Harbor’s delay is common. Options when the clock runs out:

Unanimous extension — holders agree to push maturity 6–12 months, sometimes at higher interest. Requires chasing every signature; one holdout can block.
Automatic conversion at cap — some notes convert into shadow preferred or common at the cap without a priced round. Dilutes before you have new cash; may scare Series A lead who wants a clean cap table.
Repayment — legally valid; practically rare unless the company is profitable or has bridge cash. Default risk if you cannot pay.
Note swap — exchange outstanding notes for SAFEs or a new note with worse cap. Transaction costs and investor relations damage.

Model maturity dates in your cash-flow forecast the day you sign. If your realistic Series A timeline is 24 months, do not sign 18-month notes without extension language or unanimous-consent waiver thresholds.

Stacking multiple notes

Harbor issued three tranches over nine months at identical terms thanks to an MFN clause. Each tranche accrues interest from its own closing date. At Series A, aggregate converting balance was $2.27M (principal + interest), not $2.1M.

Different caps across tranches create the same stacking headaches as overlapping SAFEs: model each holder separately, then sum fully diluted ownership. A later note at a lower cap converts more shares per dollar, shifting ownership from founders and earlier angels. Series A leads often require cleaning the cap table — converting all notes on identical terms or buying out small holders — before they wire.

Harbor Analytics cap-table walkthrough

Pre-seed: founders 8,000,000 common (80% of 10M authorized). Three notes: $900k, $700k, $500k at 6%, signed Jan / Apr / Sep 2024, all 18-month maturity.

Nov 2025: two notes mature. Extension signed Dec 2025 with 8% PIK for six months on $1.6M combined principal; $500k Sep note still inside original maturity.

Apr 2026 Series A: $4M new money at $18M pre. Total converting: $2.27M. Cap conversion at $1.40/share yields ~1.62M preferred shares to noteholders (~12.1% post-round FD). New investors: $4M ÷ $1.80 ≈ 2.22M shares (~16.7%). Founders diluted from 68% pre-note-conversion model to 61% actual (interest + extension PIK). The 7-point gap versus the board deck was almost entirely ignored interest and PIK.

Technique decision table

Instrument	Founder upside	Investor protection	Best when	Watch out
Convertible note	Fast close, familiar to angels	Interest, maturity, seniority in wind-down	Bridge between priced rounds; intl markets	Maturity crunch; interest dilution
Post-money SAFE	No maturity; no interest accrual	Cap/discount only; weaker in shutdown	Standard US seed; YC ecosystem	Cap stacking; ownership fixed at sign
Priced seed preferred	Clean cap table day one	Full preferred rights immediately	Lead investor wants board seat + terms now	Legal cost; sets valuation early
Revenue-based financing	Non-dilutive if repaid	Cash repayment from revenue	Profitable unit economics; SaaS with ARR	Not equity; covenant pressure
Venture debt	Extends runway without priced round	Collateral, covenants, warrants	Post-Series A with ARR collateral	Wrong stage for pre-revenue seed
Note → SAFE swap	Removes maturity overhang	Investors may demand worse cap	Maturity wall with cooperative holders	Re-negotiation fatigue

Common pitfalls

Ignoring accrued interest in dilution models — 6% over two years on $2M adds $240k of extra shares at conversion.
Maturity shorter than realistic fundraise timeline — enterprise sales cycles routinely push Series A past 18 months.
No extension mechanics — requiring 100% holder consent gives one angel veto power.
Qualified financing set too high — a $3M threshold blocks conversion on a $2M inside round, leaving notes alive.
MFN without tracking — later investor auto-inherits better cap; founders forget to update the model.
Assuming cap and discount stack — conversion is better-of, not both.
Side letters lost in data room — pro-rata and information rights buried in email, not the note form.
Tax treatment surprises — OID (original issue discount) and accrued interest can have 1099 implications; consult counsel.

Production checklist

Model conversion shares including principal + accrued interest + any PIK.
Set maturity at least 6 months beyond realistic Series A close date.
Define qualified financing minimum aligned with your fundraise plan.
Negotiate majority-holder extension threshold (e.g. 66% consent).
Document cap, discount, better-of math in a shared cap-table spreadsheet.
Track MFN: any new note auto-updates prior holders’ terms.
Calendar maturity dates with 90-day warning alerts to investors.
Align note conversion series with Series A preferred terms (no orphan classes).
Compare note package against post-money SAFE economics before signing.
Retain counsel for extension amendments — do not reuse stale templates.

Key takeaways

Convertible notes are debt with a maturity clock — interest accrues and converts into extra dilution.
Cap and discount are better-of at conversion, same logic as SAFEs but applied to principal plus interest.
When Series A slips past maturity, extensions and PIK renegotiation burn cash and founder ownership.
Harbor Analytics underestimated dilution by ~7 points because models ignored $127k accrued interest and extension PIK.
For standard US seed with no bridge urgency, post-money SAFEs usually beat notes on simplicity — notes still matter for bridges and international deals.