Convertible promissory notes, commonly referred to as convertible notes, are debt instruments sold by companies to raise money. Often, convertible notes are used during a seed round before the company has raised any equity financing, or as a bridge round in between equity financings.
Companies may choose to use convertible notes, or similar instruments like SAFEs, to postpone setting a company valuation until a later milestone or round of financing and because such instruments are usually simpler to negotiate and close compared to an equity financing deal.
As debt instruments, convertible notes bear interest and have a maturity date upon and after which an investor can demand repayment if the convertible note is still outstanding. Despite the debt characteristics of convertible notes, startups and their investors usually expect that the principal and interest on convertible notes will not be repaid, but instead will convert into equity in the company when certain events, such as a later equity financing, occur. Since seed and bridge investments are considered to be risky, convertible notes often feature a discount or a valuation cap, which entitle convertible note investors to convert their investments into a company’s equity at a lower price than later investors in the company would pay for the equity.