What Is a Convertible Note?
A convertible note is a debt instrument that converts into equity at a later date, typically during a priced funding round (Series A). As a foreign investor, I find convertible notes attractive because they defer the valuation question to when the company has more traction.
When you invest via a convertible note, you're technically making a loan to the startup. The company owes you the principal plus interest. However, instead of repaying cash, the debt converts into shares when specific triggering events occur.
Why Foreign Investors Like Convertible Notes
Convertible notes provide a clear paper trail of your investment, which matters for visa applications (EB-5, E-2) and tax documentation. The promissory note structure is well-understood by banks and immigration officers alike.
Key Terms You Must Understand
Valuation Cap
The valuation cap sets a maximum company valuation at which your note converts to equity. If the Series A values the company higher than your cap, you convert at the cap price - getting more shares for your investment.
Example: You invest $100,000 with a $5M cap. The Series A prices the company at $10M. Your note converts as if the company were worth $5M, giving you twice the shares you'd get at the actual valuation.
Discount Rate
The discount rate gives you a percentage reduction on the Series A share price. Common discounts range from 15% to 25%. This rewards you for the risk of investing early.
Example: With a 20% discount, if Series A shares cost $1.00, you pay only $0.80 per share when your note converts.
Interest Rate
Convertible notes accrue interest (typically 4-8% annually). The accrued interest adds to your principal and converts to additional shares. The IRS requires a minimum interest rate (AFR) for the note to be considered bona fide debt.
Maturity Date
The maturity date is when the loan becomes due if no conversion event has occurred. Typical terms are 18-24 months. At maturity, the company must either repay the note, convert it, or negotiate an extension with you.
| Term | Typical Range | Investor-Friendly |
|---|---|---|
| Valuation Cap | $2M - $20M | Lower cap = better |
| Discount Rate | 15% - 25% | Higher discount = better |
| Interest Rate | 4% - 8% | Higher rate = more shares |
| Maturity | 18 - 24 months | Shorter = more pressure to convert |
Convertible Notes vs. SAFEs
Y Combinator's SAFE (Simple Agreement for Future Equity) has become popular, but convertible notes remain the standard for many investors. Here's how they compare:
| Feature | Convertible Note | SAFE |
|---|---|---|
| Legal Structure | Debt instrument | Equity-like warrant |
| Interest Accrual | Yes (IRS required) | No |
| Maturity Date | Yes (negotiated) | No |
| Repayment Right | At maturity if no conversion | No repayment right |
| Documentation | More complex | Simpler |
| Tax Treatment | Clearer (debt) | Less certain |
My Recommendation for Foreign Investors
I generally prefer convertible notes over SAFEs for foreign investors. The debt classification provides clearer tax treatment, and the maturity date gives you leverage if the company stalls. Banks also understand promissory notes better when you need to document source of funds.
Conversion Triggers
Your convertible note will specify which events trigger conversion to equity:
- Qualified Financing: A priced equity round above a minimum threshold (e.g., $1M). This is the most common trigger.
- Change of Control: If the company is acquired before conversion, you typically receive either a multiple of your investment (1.5x - 2x) or convert and participate in the sale proceeds.
- IPO: A public offering triggers automatic conversion at your cap or discount.
- Maturity: If no trigger occurs, conversion terms at maturity are negotiated or specified upfront.
Convertible Note Generator
Generate a customized convertible note agreement with your specific terms. Configure valuation cap, discount, interest rate, and maturity date.
Negotiation Tips for Investors
- Get both cap AND discount: The "better of" provision means you convert at whichever gives you more shares. Always negotiate for both protections.
- Watch the qualified financing threshold: If set too high, the company could raise just under it in multiple rounds without triggering conversion.
- Include information rights: As a debt holder, you should receive quarterly financial updates and notice of material events.
- Pro-rata rights: Secure the right to invest in future rounds to maintain your ownership percentage.
- Most Favored Nation (MFN) clause: If the company issues notes on better terms to later investors, your terms automatically improve to match.
Tax Considerations for Foreign Investors
As a non-US person investing via convertible notes, consider these tax implications:
- Interest income: Accrued interest may be subject to 30% withholding (or lower if your country has a tax treaty with the US).
- Conversion: The conversion itself is generally not a taxable event - you're exchanging debt for equity.
- Capital gains: When you eventually sell your converted shares, gains may qualify for favorable treatment if the company meets QSBS requirements.
- FIRPTA: If the company owns US real estate, your sale proceeds may be subject to FIRPTA withholding.
QSBS Opportunity
If your converted shares qualify as Qualified Small Business Stock (QSBS), you may be able to exclude a significant portion of your gains from US tax. However, QSBS benefits are complex for foreign investors - schedule a consultation to understand your specific situation.
Ready to Invest in a Startup?
I'll help you structure your investment, negotiate favorable terms, and ensure proper documentation for immigration and tax purposes.
Sergei Tokmakov, Attorney — California Bar #279869