What Is a Convertible Loan for Startups?

A convertible loan is a short‑term loan that can be exchanged for equity instead of being repaid in cash. The lender provides cash now, earns any agreed‑upon interest, and later receives shares based on the loan's conversion terms. Key clauses are the valuation cap (the highest company valuation used to price the conversion), the discount (a percentage reduction on the price per share at the next financing), the conversion trigger (usually the next priced equity round), and the maturity date (when the loan must be repaid if conversion hasn't occurred).

When the trigger event happens, the loan amount (plus interest) is divided by the effective share price - whichever is lower after applying the cap or discount - to calculate how many shares the lender gets. A lower cap or larger discount means the lender receives more equity, which can dilute existing shareholders. Before signing, read the term sheet carefully, confirm how each clause is calculated, and have a lawyer verify that the agreement complies with your jurisdiction's rules.

Convertible loan makes sense when you need cash now but can wait for a priced equity round, and when setting a valuation would be premature. It is most common for pre‑seed or early‑seed companies that anticipate a financing event within the next 12‑18 months and have investors who understand debt‑like instruments.

Use this quick checklist: (1) You have a clear timeline to raise a priced round; (2) Your investors are comfortable with interest accrual and a future conversion event; (3) You can absorb the dilution that a valuation cap or discount will create; and (4) You lack the bargaining power or market data to negotiate a fair equity price today.

If you meet most items, run a simple dilution model using your expected cap and discount, then review the terms with legal counsel before proceeding. If any key item is missing, explore alternatives such as a SAFE or a direct equity raise.

A convertible loan is a poor fit when the startup's circumstances make the future equity conversion costly, uncertain, or strategically misaligned.

• You already have a reliable, market‑driven valuation and prefer a straightforward equity round; a convertible loan would delay pricing and add conversion mechanics.
• Your cash flow cannot comfortably cover any accrued interest or repayment trigger, increasing the risk of default before conversion.
• Future financing is unlikely or may never occur, leaving the loan as permanent debt on the balance sheet.
• The intended investors demand extensive protective clauses (e.g., high liquidation preferences) that would outweigh the simplicity convertible notes are meant to provide.
• The cap table is already heavily diluted, and additional conversion‑induced dilution would jeopardize founder control or future fundraising caps.
• Your jurisdiction imposes strict securities or debt regulations on convertible instruments, making compliance burdensome.
• You need capital quickly without giving investors equity upside, and a straight‑line loan or alternative financing (e.g., revenue‑based financing) matches the risk profile better.
• The expected conversion discount or valuation cap is so aggressive that it would give investors an outsized ownership slice relative to the capital received.

Always verify interest obligations, conversion triggers, and local legal requirements before proceeding.

The conversion happens automatically once the pre‑defined trigger event occurs, usually a qualified equity financing. Follow these actions in order to complete the process correctly.

1. Confirm the trigger - Verify that the financing round meets the loan's trigger criteria (minimum raise amount, investor type, etc.) as defined in the loan agreement.
2. Retrieve the agreed‑upon terms - Pull the valuation cap, discount rate, and any most‑favored‑nation (MFN) provisions from the convertible note documents.
3. Compute the conversion price -
   • Start with the price per share set by the new round.
   • Apply the discount (e.g., 20 % off) or the valuation cap, whichever yields the lower price per share.
4. Determine share quantity - Divide the outstanding principal plus accrued interest by the conversion price to get the number of shares the note will convert into.
5. Check for rounding rules - Some agreements require rounding down to the nearest whole share; follow the specific clause in your note.
6. Issue the shares - Have the company's secretary or legal counsel update the cap table to reflect the new shares, allocate them to the noteholder, and record any resulting dilution.
7. Notify stakeholders - Send a concise notice to the investor, existing shareholders, and the board confirming the conversion details and updated ownership percentages.
8. Finalize documentation - Execute any required conversion statements, update the corporate ledger, and file any statutory notices (e.g., Form D for U.S. offerings) if applicable.
9. Close out the loan - Mark the convertible note as 'converted' in your internal financing tracker and adjust any related accounting entries.
10. Review next steps - After conversion, refer to the 'how valuation caps and discounts affect your equity' section for insight on the impact to existing shareholders and prepare for any subsequent financing rounds.

Safety note: Always double‑check the specific language in your convertible loan agreement before proceeding, as terms can vary between issuers.

The valuation cap and the discount together set the conversion price, which directly determines how many shares your loan becomes and how much founder equity is diluted.

Example (pre‑money convention, same assumptions used throughout):

• Startup's pre‑money valuation before the next round: $8 M
• Valuation cap in the note: $5 M
• Discount rate: 20 %
• Convertible loan amount: $250 k
• Existing shares before conversion: 8 M (implies $1 per share at a $8 M valuation)

How the two terms interact

• Base price per share = $8 M ÷ 8 M shares = $1.00
• Discounted price = $1.00 × (1  -  20 %) = $0.80 per share
• Capped price = $5 M ÷ 8 M shares = $0.625 per share

The note converts at the lower of the discounted price and the capped price, so in this case the capped price ($0.625) applies.

• Shares issued to the loan = $250 k ÷ $0.625 ≈ 400 k shares
• Post‑conversion shares = 8 M + 400 k = 8.4 M shares
• Founder ownership after conversion = (founder shares ÷ 8.4 M) × 100 % (e.g., if founders held 6 M shares, they now own ~71 %).

Key points to verify

• Whether the cap is quoted on a pre‑money or post‑money basis (the calculation changes accordingly).
• The exact discount percentage and any 'most‑favored‑nation' clauses that could further lower the price.
• How many shares are outstanding at the time of conversion (including any other convertible instruments).

Double‑check these terms in the convertible agreement and run the numbers with your accountant or legal counsel before the financing closes. This prevents unexpected dilution and keeps the cap table transparent.

• Example 1 - 20 % discount, no valuation cap
  
  Assumptions: pre‑money valuation $5 M, new equity round $2 M, convertible loan $0.5 M, 20 % discount, no cap.
  
  Conversion price: $5 M × 0.80 = $4 M.
  
  Post‑money pool: $5 M + $2 M + $0.5 M = $7.5 M.
  
  Loan equity: $0.5 M ÷ $4 M ≈ 12.5 % of the post‑money.
  
  Founder ownership: drops from 66.7 % (founder $5 M ÷ $7.5 M) to about 58.3 % after conversion.
• Example 2 - $4 M valuation cap, no discount
  
  Assumptions: same as Example 1, but the loan carries a $4 M cap and no discount.
  
  Conversion price: capped at $4 M (lower than the $5 M pre‑money).
  
  Loan equity: $0.5 M ÷ ($4 M + $2 M) ≈ 8.33 % of the post‑money.
  
  Founder ownership: falls from 66.7 % to roughly 61.1 % after conversion.
• Example 3 - 20 % discount + $3.5 M cap
  
  Assumptions: same baseline, loan has both a 20 % discount and a $3.5 M cap.
  
  Effective price: discount yields $4 M, but the cap is lower, so conversion uses $3.5 M.
  
  Loan equity: $0.5 M ÷ ($3.5 M + $2 M) ≈ 9.09 % of the post‑money.
  
  Founder ownership: declines from 66.7 % to about 60.0 % after conversion.

Always run the exact numbers from your loan agreement to confirm the actual dilution.

When drafting a convertible loan, focus on negotiating valuation cap, discount rate, maturity date, interest rate, conversion trigger, and repayment provisions. Each represents a trade‑off between protecting founder equity and giving the investor a fair upside.

A tighter valuation cap or larger discount rate reduces dilution but may deter investors who prefer a lower upside; a longer maturity date gives the startup more runway yet postpones the investor's exit. A modest interest rate adds cash‑flow pressure but can improve the conversion price, while a clear conversion trigger - such as a qualified financing round - avoids ambiguous timing. Finally, negotiate repayment provisions (cash‑only, convertible, or hybrid) to balance risk if the loan never converts. Review the final language with counsel before signing.

Founders often lose more equity than necessary by overlooking how key terms shape conversion. Review each pitfall and adjust before you sign the convertible loan.

Common pitfalls include:

• Setting a high discount - a larger discount (for example 20 %) lowers the conversion price, giving investors a bigger slice of post‑money equity; a modest or zero discount protects founder ownership.
• Using a low valuation cap - the cap defines the maximum pre‑money valuation for conversion; a cap below your realistic next‑round valuation forces conversion at a cheaper price and amplifies dilution.
• Neglecting future financing scenarios - if the cap or discount does not account for anticipated higher‑valued rounds, the conversion can eat into equity that you expected to retain.
• Skipping interest‑accrual calculations - accrued interest converts to shares alongside the principal; forgetting this adds hidden dilution.
• Overlooking conversion triggers - automatic conversion upon a qualified financing or maturity can happen earlier than planned, turning a loan you thought was temporary into permanent equity.

Double‑check the discount, cap, interest, and trigger clauses against the 'negotiate 6 key convertible loan terms' guidance, and run a dilution model as described in the cap‑table examples before finalizing the agreement. This extra sanity check helps keep founder equity where it belongs.

Convertible loans stay on the books as a liability until they convert, at which point they are re‑classified as equity.

For tax purposes the borrower can usually deduct any interest paid, while the lender reports that interest as ordinary income. When conversion occurs the borrower typically has no tax event, but the lender may recognize capital gains (or a loss) on the difference between the loan's adjusted basis and the fair market value of the shares received. If the conversion includes a discount or a valuation cap that effectively gives the lender a lower price than market, the discount can be treated as compensation to the founder and may be taxable as ordinary income. These rules differ by country and sometimes by state, so verify the treatment that applies to your jurisdiction.

In accounting, record the cash received as a 'convertible note payable' (or similar liability) and accrue interest expense over the loan term. When the note converts, remove the liability from the balance sheet and increase the equity accounts - typically common stock at par value and additional paid‑in‑capital for the excess. The exact journal entries depend on the applicable accounting framework (e.g., U.S. GAAP vs. IFRS) and any specific terms of the note.

Because tax outcomes and accounting entries can vary widely, run the numbers with a qualified CPA or tax advisor before finalizing a convertible loan. 

If the conversion trigger never occurs, the startup must either repay the loan or face alternative outcomes such as renegotiation, default, or a forced conversion at maturity.

Repayment is the default route in most standard convertible notes. At the agreed‑upon maturity date, the borrower returns the principal plus any accrued interest in cash. This usually requires sufficient cash reserves or a new financing round to cover the amount; otherwise the lender may consent to an extension or a revised payment schedule, but those changes are not automatic and must be negotiated.

If repayment is not feasible, the parties often renegotiate the terms. Some agreements allow the lender to convert the debt into equity at a pre‑set price even without a trigger event, effectively treating the maturity as a conversion date. When renegotiation fails, the loan can be deemed in default, giving the lender rights to enforce any security interest, claim penalties, or pursue legal action. The specific remedies depend on the note's language and the jurisdiction, so reviewing the original agreement and consulting counsel is essential.