Why Use a Convertible Note
A convertible note solves the valuation problem. At pre-seed or very early seed stage, neither you nor your investors have enough data to agree on a fair company valuation. Revenue is zero or near zero, the product may be a prototype, and comparable company data is unreliable.
Rather than spending weeks negotiating a valuation that both parties know is guesswork, a convertible note defers the pricing to the next round — when a lead investor with a term sheet will set the price based on actual traction. The early investor gets a reward for taking more risk (via the discount and/or cap), and you get capital faster with lower legal costs.
Typical legal costs for a convertible note in the UK are £2,000-£5,000, compared to £10,000-£25,000 for a priced round with full investment agreements. For a £50K-£250K angel round, the savings are material.
The 8 Key Terms in Every Convertible Note
These are the terms that matter. Every one of them affects how much equity the note holder ends up with — and therefore how much you give up.
1. Principal Amount
The amount of money the investor is lending. This is the starting number from which all conversion calculations flow. A £100K note with no interest converts £100K of value into shares. Simple — until you add the other terms.
2. Interest Rate
UK convertible notes typically carry 4-8% annual interest. The interest accrues and converts alongside the principal — it does not get paid in cash. A £100K note at 6% that converts after 18 months converts £109K of value (principal + accrued interest). HMRC treats this as real interest for tax purposes.
3. Valuation Cap
The maximum valuation at which the note converts. If you set a £2M cap and your next round prices at £5M pre-money, the note converts at the £2M cap — giving the note holder 2.5x more shares than if they invested at the round price. Caps typically range from £1M to £5M for UK pre-seed rounds.
4. Discount Rate
The percentage discount applied to the next round's price per share. A 20% discount means the note holder pays 80p for every £1 share. Standard range is 15-25%. If both a cap and discount apply, the note converts at whichever produces more shares for the investor.
5. Maturity Date
The date by which the note must either convert or be repaid. Typically 12-24 months. At maturity, if no qualifying round has occurred, the investor can demand repayment (which most startups cannot do) or the note converts automatically at a pre-agreed valuation.
6. Qualifying Round Threshold
The minimum size of the next equity round that triggers automatic conversion. Typically £250K-£1M. This prevents the note from converting on a tiny friends-and-family round that does not represent a real market valuation.
7. Conversion Mechanics
The specific formula that determines how many shares the note holder receives. Most notes convert into the same share class issued in the qualifying round (e.g., Series Seed preferred). The conversion price is the lower of: (cap valuation / fully diluted share count) or (round price per share x (1 - discount rate)).
8. Maturity Conversion Floor
The valuation at which the note converts if it reaches maturity without a qualifying round. Without this clause, the investor can demand cash repayment. With it, the note converts automatically — protecting the company from a cash crisis. The floor is typically set at the valuation cap or lower.
Worked Example: How a Convertible Note Converts
Sarah invests £100,000 into your company via a convertible note. The terms: £2M valuation cap, 20% discount, 6% interest, 18-month maturity.
Twelve months later, you raise a seed round at £4M pre-money valuation. There are 10,000,000 fully diluted shares. The seed round price per share is £0.40 (£4M / 10M shares).
Using the cap: Conversion price = £2M / 10M shares = £0.20 per share. Sarah's note (£100K + £6K accrued interest = £106K) converts at £0.20 = 530,000 shares.
Using the discount: Conversion price = £0.40 x 0.80 = £0.32 per share. £106K at £0.32 = 331,250 shares.
The cap produces more shares (530,000 vs 331,250), so Sarah converts at the cap. She ends up with 5.3% of the company on a fully diluted basis — compared to 2.65% if she had invested at the round price. The cap rewarded her for investing 12 months earlier when the risk was higher.
UK-Specific Considerations
SEIS/EIS compatibility: Convertible notes are debt, not equity. SEIS and EIS require shares to be issued. If your investor needs tax relief, use an advance subscription agreement (ASA) instead — it achieves the same economic outcome but structures the investment as a share subscription rather than a loan. Most UK startup lawyers can draft an ASA that mirrors convertible note terms while preserving SEIS eligibility.
Companies House filings: A convertible note does not require a Companies House filing until conversion. When the note converts, you must file a Return of Allotments (SH01) within one month of issuing the new shares. Late filing is a criminal offence for directors — set a reminder.
Tax on accrued interest: HMRC treats accrued interest on convertible notes as taxable income for the investor, even though they do not receive cash. The company may also need to account for it as a deductible expense. Get your accountant involved before the note matures.
Stamp duty: The issue of new shares on conversion of a note is exempt from stamp duty because no transfer of existing shares occurs. This is a minor but helpful cost saving compared to a share purchase.
The Advance Subscription Agreement Alternative
For UK founders, the advance subscription agreement (ASA) is often the better choice. It works like a convertible note — deferred pricing, cap, discount — but it is structured as a subscription for shares rather than a loan. This means shares are issued immediately (or as soon as practicable), which triggers SEIS or EIS eligibility.
The key difference: with an ASA, the investor receives shares at the time of investment, but the price per share is adjusted retroactively when the next round closes. Additional shares are issued (or existing shares re-designated) to reflect the cap or discount. With a convertible note, no shares exist until conversion.
The SeedLegals ASA and the British Business Bank's template are widely used starting points. Legal costs are similar to a convertible note — £2,000-£5,000 for a straightforward deal.
Common Traps to Avoid
No Valuation Cap
A convertible note without a cap gives the investor no downside protection. If your company raises at a high valuation, the note converts at that price — the investor gets no reward for investing earlier. Most experienced angels will refuse to invest without a cap.
Stacking Multiple Notes
Raising multiple convertible notes with different caps and discounts creates a conversion waterfall that is difficult to model and produces unexpected dilution. Each note converts separately, and the resulting cap table can be significantly worse for founders than expected. Model all outstanding notes together before issuing a new one.
Ignoring the Maturity Date
If you have not raised a qualifying round when the note matures, you have a problem. The investor can demand repayment, and if you cannot pay, this can trigger insolvency. Always negotiate an automatic conversion at maturity as part of the original note terms.
Forgetting Pro-Rata Rights
Some convertible notes include a right for the note holder to participate in the qualifying round (pro-rata). This means they can invest additional money at the round price on top of their note conversion. If multiple note holders have pro-rata rights, the round can fill up before you have room for a lead investor.
CapBrief
Model Convertible Note Conversion on Your Cap Table
Upload your cap table and CapBrief shows exactly how each convertible note converts at different round sizes and valuations — before you sign the term sheet.
Try CapBrief Free →Frequently Asked
What is a convertible note?
A convertible note is a short-term loan that converts into equity at a future priced round. The investor lends money to the company, and instead of being repaid in cash, the loan converts into shares when the company raises a qualifying equity round. The conversion typically happens at a discount to the round price, rewarding the early investor for taking more risk. In the UK, convertible notes are structured as loan agreements with conversion mechanics, interest provisions, and maturity dates.
What is the difference between a convertible note and a SAFE?
A convertible note is a debt instrument with an interest rate and maturity date — it creates a legal obligation for the company to repay the money if conversion does not happen. A SAFE (Simple Agreement for Future Equity) is not debt: it is a contractual right to future shares with no maturity date, no interest, and no repayment obligation. In the UK, SAFEs have gained popularity but are less common than in the US because they do not qualify for SEIS/EIS tax relief (the shares have not been issued yet). Most UK angel rounds still use convertible notes or advance subscription agreements (ASAs) to preserve SEIS eligibility.
What is a valuation cap on a convertible note?
A valuation cap is the maximum company valuation at which the note converts into equity. If the company raises its next round at a higher valuation than the cap, the note converts at the cap — giving the note holder more shares per pound invested. Example: an investor puts £100K into a note with a £2M cap. The company later raises at a £5M pre-money valuation. Without the cap, £100K buys 2% (100K/5M). With the cap, £100K buys 5% (100K/2M). The cap is the investor's upside protection.
What is a typical discount rate for a UK convertible note?
Typical discount rates in the UK range from 15% to 25%. A 20% discount is the most common. This means the note converts at 80% of the price paid by the next round investors. Some notes have both a cap and a discount, with conversion at whichever gives the note holder more shares. Others have only one or the other. Having both gives the investor the best possible deal in all scenarios.
What happens if the convertible note reaches maturity without a qualifying round?
This is the scenario nobody wants. The investor can technically demand repayment — which most early-stage startups cannot afford. In practice, the options are: (1) extend the maturity date by mutual agreement, (2) convert at a pre-agreed floor valuation, (3) renegotiate entirely. Good convertible note templates address this explicitly with an automatic conversion at maturity provision, typically at a predetermined valuation. Without this clause, you are at the mercy of the note holder's goodwill.
Are convertible notes SEIS/EIS eligible?
Not directly. SEIS and EIS tax relief requires shares to be issued. A convertible note is debt until conversion. However, advance subscription agreements (ASAs) — which are economically similar — can be structured to be SEIS/EIS eligible because the investor is subscribing for shares in advance rather than lending money. If SEIS/EIS eligibility matters (it almost always does in the UK), use an ASA rather than a convertible note, or issue shares alongside the note.