Why Convertible Debt Reigns Supreme for Early-Stage Startups
- Stephanie Pflaum
- Sep 2
- 7 min read
Updated: Sep 4
When your startup is fresh out of the garage with little more than a pitch deck and a dream, valuing your company can feel like signing up to run a marathon without any preparation. That’s why convertible debt remains popular among early-stage startups and investors: it allows both sides to delay the valuation debate until there's more substance to argue over.
What is Convertible Debt?
Convertible debt (usually via a convertible note) starts as a loan from investors to your startup—but instead of being repaid in cash, it converts into equity (shares) when you raise your next financing round.
Convertible Debt vs. Convertible Notes
Though often used interchangeably, convertible debt refers to the financing structure and the convertible note is the signed contract. So, when founders and investors talk about “raising on a convertible note,” they mean they’re using convertible debt as the funding tool.
How Does It Work?
Investors give you cash in exchange for a promissory note (like an IOU). The funding starts as debt, accrues interest, and has a maturity date. At your next qualified equity round, your Series A for example, the debt converts into shares that investors usually get at a discount. If no conversion event happens before the maturity date, investors can demand repayment or renegotiate the debt. Think of it as a bridge with debt at the beginning and equity at the destination.
Do Convertible Notes Dilute Shares?
Yes, but not right away—you’ll keep more ownership today and give it up when the note converts. Equity dilution, however, is often more than expected from convertibles. This could be because you’ve stacked multiple notes, set valuation caps too low, or missed important terms in the fine print that overwhelmingly benefit investors. Savvy founders take the time to model conversion scenarios before taking on convertible notes.
We’ll explain what you need to look out for shortly.
GO DEEPER
A Funding Landscape in Favor of Convertibles
Companies that can't justify lofty valuations need a reasonable alternative—that’s most SaaS startups these days. Investors want to see stronger fundamentals, operational efficiency, and disciplined growth. But many startups need outside capital to get started and eventually meet investors’ increasingly high expectations for growth capital.
Early-stage funding options
It might seem like there are plenty of funding options for early-stage startups, but they aren’t much of an option when they’re almost impossible to get. Here are three funding solutions most founders consider:
Bank loans
Banks are reluctant to fund new companies without significant hard assets or annual revenues in excess of $5 million. This makes it virtually impossible for a pre-revenue tech startup to secure a traditional bank loan—unless one or more of the co-founders are willing to personally guarantee the loan with hard assets, such as homes, retirement funds, and life savings.
Revenue-based financing
This is a great way for a bootstrapped SaaS business to accelerate growth, once you have revenue. Since revenue-based investors underwrite loans against recurring revenue streams, they’re unable to fund pre-revenue companies. And most will want you to hit a revenue benchmark before they fund you.
Venture capital/Series A
Unless you have a successful track record as an entrepreneur, it’s almost impossible to interest venture capital investors in a Series A round if you’re pre-revenue. Over the years, the average Series A round has moved later and later in the company’s development. Now it’s rare to raise a Series A without some revenue or other validated traction in the market.
Convertibles Appeal to Both Sides
Convertibles offer both entrepreneurs and investors an appealing funding structure, particularly during early pre-revenue stages. Founders get immediate capital with less dilution today, and investors get downside protection through the debt component. Convertible notes delay the tricky business of valuing early-stage startups and accelerate fundraising deals for both parties. Additionally, modern convertibles can offer strategic flexibility with few operating restrictions.
Why Founders Like Convertible Notes
The main appeal of convertible debt for early- and seed-stage companies is that it delays the debate over a company’s value. You might have a ground-breaking idea, but if the business has no revenue, no prototype, and no evidence of appetite in the market, you and your investors are likely to have wildly different perceptions of the company’s value.
Issuing convertible notes in exchange for funding lets your startup punt on the valuation question until your next equity round, when hopefully the company is a lot more robust and has a lot more data to back up a strong valuation.
Convertible debt advantages for founders:
Fast, streamlined financing. Convertible debt is debt dressed in a blazer—a simple IOU that converts to shares later. No elaborate equity negotiations or shareholder rights to slow you down.
Deferred dilution. You keep more control while proving your product-market fit. The actual equity split happens later, after demonstrating traction.
Investor incentives. Early investors get a discount—often around 20%—and sometimes a valuation cap, offering upside when your valuation takes off.
Why Investors Like Them
Generally speaking, VCs would rather snap up your preferred stock than issue convertible debt. Convertible debt is riskier and gives them less control, but there are still plenty of incentives for early investors that strongly believe in your idea.
If your business fails and your assets are liquidated, debt gets paid off before equity, so your convertible debt providers have slightly more protection than your equity investors. That said, early-stage startups don’t usually have much in the way of liquidation value.
Convertible debt advantages for investors:
Risk-mitigated upside. Convertible debt starts as debt—with interest and maturity—but converts to equity in the good times.
Simpler documentation. Compared to the labyrinth of agreements in equity rounds, convertible notes are surgically focused—less legal overhead, more speed.
Valuation cap + discount = better IRR. It rewards early believers if the company explodes in value, giving them the right to buy shares at a lower price than later equity investors.
Find the right funding strategy for your startup
Most entrepreneurs see venture capital as the holy grail of funding solutions, but fewer than 0.05% of U.S. startups ever raise a VC round.
There are other startup fundraising options, and some might be more advantageous for your business. This guide will help you decide what kind of capital to raise, when to raise it, and what you need to get it.
Before You Sign That Note, Dig Into the Details of the Deal
Depending on how quickly you want to move on raising your next funding round and your expected growth trajectory, it is sometimes more beneficial to skip the convertible notes and go straight into a priced equity round.
If you’re considering convertible debt to fund your startup, you’ll want to make sure that the terms benefit you, and that early investors are fairly compensated. Here’s a tactical checklist to help you pore through the specifics of convertible debt deals:
1. Valuation Cap & Discount
Do they lock in a maximum valuation? That cap—and the discount rate—dictate how much equity early backers get. It's how you define the payoff for their early risk. Convertible debt providers typically get a 20 to 30% discount on equity in later rounds. A valuation cap really only benefits investors, who may want an additional incentive.
2. Maturity Date & Interest
Convertible notes are debt. They accrue interest (typically 4 to 8% a year), and if no conversion triggers occur by maturity, investors can demand repayment. Many companies issue convertible debt that matures in one year. But what happens if that year is up and you still haven’t reached the conditions set for conversion? You’ll either need to cough up the cash or you’ll need to get the investors to agree to extend the maturity date of the note.
3. Conversion Triggers
A "qualified financing round"—often Series A—is the usual trigger. Some notes convert automatically; others give investors the option of converting when conditions are met. Know which side you're on and when the swap happens.
4. Legal Clarity & Simplicity
Convertible notes are cleaner than equity rounds, but clarity is still key. Ensure your note covers all essential terms: interest, valuation cap, trigger, default scenario.
5. The Dilution Trade-Off
Yes, you'll give up equity later. But with well-structured caps and discounts, you strike a balance. So, if you want to raise early, move fast, prove growth, and delay dilution, consider what that is worth to you in terms of equity.
Convertible Risks
Convertible debt can be a great way to raise startup capital early on, but you need to understand the risks and potential costs. Here are terms and conditions you should pay close attention to:
Stacking liquidation preference multiples. These can mess up your cap table and trap you in unfavorable exit tunnels. Convertibles are meant to be simple—don’t over-complicate with terms favoring investors at your expense.
Valuation caps. They protect investor’s upside risk by setting a floor on their purchase price, but they offer no benefit for entrepreneurs aside from incentivizing investors.
Look out for full ratchet anti-dilution rights. This provision reprices the investor’s shares in the case of a down round, which will severely dilute the owner’s equity.
Default dangers. Missing the maturity—not securing the next round by the maturity date—could force repayment and that’s going to be tough for most cash-burning startups. It’s one of the key reasons some founders prefer SAFEs, which have no maturity date or repayment obligation.
Misaligned timing incentives. Founders may want to delay converting to avoid dilution; investors may be itching to convert early. Clear rules help avoid conflict.
Convertible Notes: The Fair Early Funding Compromise
Convertible debt helps you get back to what matters—building your product—while giving early investors upside without thorny valuation fights. For entrepreneurs juggling everything, it's a pragmatic choice. But like any smart founder, you have to read the fine print to understand interest rates, caps, conversion triggers, defaults, dilution, and more.
