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Investment & Equity
Convertible Note
In short
A debt instrument that converts into equity at a future priced round, typically at a discount (usually 15–25%) to the next round's price and with a valuation cap that limits the price at which the note converts.
A debt instrument that converts into equity at a future priced round, typically at a discount (usually 15–25%) to the next round's price and with a valuation cap that limits the price at which the note converts. Convertible notes are common in Indian early-stage deals because they allow startups to raise money quickly without negotiating a valuation — the valuation is deferred until the next round. The note accrues interest (typically 8–12% per annum) and has a maturity date (usually 18–24 months), though extensions are common. If the startup fails to raise a priced round before maturity, the note may convert at a pre-agreed valuation or become repayable.
How It Works
A convertible note is a short-term debt instrument that converts into equity at a future priced funding round, typically at a discount to the round's price per share and subject to a valuation cap that limits the maximum price at which the debt converts. Convertible notes are widely used in Indian early-stage deals because they allow startups to raise money quickly without the delay, legal expense, and negotiation complexity of pricing a round. Key terms include: the discount rate (typically 15–25%, meaning the investor receives shares at a price lower than the Series A investors pay), the valuation cap (which sets a maximum pre-money valuation for conversion, rewarding early investors for taking more risk), the interest rate (typically 8–12% per annum, accrued and converted into equity), and the maturity date (usually 18–24 months, after which the note either converts at pre-agreed terms or becomes repayable). Convertible notes are considered debt on the company's balance sheet until conversion. For founders, notes are faster and cheaper to close than priced rounds, but the deferred valuation and conversion mechanics can create complexity in the cap table at the next round. For investors, notes offer downside protection (they are debt until conversion) and upside via the discount and cap.
Application Process
1. Use convertible notes for speed — they can close in 2–4 weeks vs. 8–16 weeks for a priced round. 2. Negotiate three key terms: discount rate (20% is market), valuation cap (based on what the next round might value the company at), and maturity date (24 months is standard). 3. Keep the documentation simple — standard templates from India Law Practice or law firms like Nishith Desai Associates work well. 4. Ensure all founders and the lead note investor understand the conversion mechanics. 5. At the next priced round, the note automatically converts — your lawyer handles the calculation based on the note terms.
Real-World Example
A startup raises ₹50 lakh through a convertible note from an angel network with the following terms: 20% discount to the Series A price, a ₹10 crore valuation cap, 10% annual interest, and a 24-month maturity. Eighteen months later, the startup raises a ₹25 crore Series A at a ₹100 crore pre-money valuation. The note converts at the lower of the discounted price (₹80 crore effective valuation after the 20% discount) or the cap (₹10 crore valuation). Since the cap is lower, the note holders convert at the ₹10 crore valuation — receiving equity worth 10x their investment. The founders benefit because they raised the seed capital quickly without negotiating a valuation when the company had minimal traction.
Key Takeaway
Convertible notes are the fastest, simplest way to raise early-stage capital when you do not want to negotiate a valuation. The key trade-off is that deferred valuation can create surprises at the next round — model different conversion scenarios so you understand how much equity the note holders will receive.
Frequently asked questions
What is Convertible Note?+
A debt instrument that converts into equity at a future priced round, typically at a discount (usually 15–25%) to the next round's price and with a valuation cap that limits the price at which the note converts.
How does Convertible Note work?+
A convertible note is a short-term debt instrument that converts into equity at a future priced funding round, typically at a discount to the round's price per share and subject to a valuation cap that limits the maximum price at which the debt converts. Convertible notes are widely used in Indian early-stage deals because they allow startups to raise money quickly without the delay, legal expense, and negotiation complexity of pricing a round. Key terms include: the discount rate (typically 15–25%, meaning the investor receives shares at a price lower than the Series A investors pay), the valuation cap (which sets a maximum pre-money valuation for conversion, rewarding early investors for taking more risk), the interest rate (typically 8–12% per annum, accrued and converted into equity), and the maturity date (usually 18–24 months, after which the note either converts at pre-agreed terms or becomes repayable). Convertible notes are considered debt on the company's balance sheet until conversion. For founders, notes are faster and cheaper to close than priced rounds, but the deferred valuation and conversion mechanics can create complexity in the cap table at the next round. For investors, notes offer downside protection (they are debt until conversion) and upside via the discount and cap.
What is the application process for Convertible Note?+
1. Use convertible notes for speed — they can close in 2–4 weeks vs. 8–16 weeks for a priced round. 2. Negotiate three key terms: discount rate (20% is market), valuation cap (based on what the next round might value the company at), and maturity date (24 months is standard). 3. Keep the documentation simple — standard templates from India Law Practice or law firms like Nishith Desai Associates work well. 4. Ensure all founders and the lead note investor understand the conversion mechanics. 5. At the next priced round, the note automatically converts — your lawyer handles the calculation based on the note terms.
What is an example of Convertible Note?+
A startup raises ₹50 lakh through a convertible note from an angel network with the following terms: 20% discount to the Series A price, a ₹10 crore valuation cap, 10% annual interest, and a 24-month maturity. Eighteen months later, the startup raises a ₹25 crore Series A at a ₹100 crore pre-money valuation. The note converts at the lower of the discounted price (₹80 crore effective valuation after the 20% discount) or the cap (₹10 crore valuation). Since the cap is lower, the note holders convert at the ₹10 crore valuation — receiving equity worth 10x their investment. The founders benefit because they raised the seed capital quickly without negotiating a valuation when the company had minimal traction.
Related Terms in Investment & Equity
Angel Investor
An individual who invests their own personal capital in early-stage startups in exchange for equity or convertible instruments. Angels are typically seasoned entrepreneurs, CXOs, or high-net-worth individuals who invest at the pre-seed or seed stage — often before institutional venture capital funds are willing to write a cheque. In India, angel investors typically invest ₹5–50 lakh per deal and many operate through formal networks like the Indian Angel Network, Mumbai Angels, and Chennai Angels, which syndicate deals and pool due diligence. Beyond capital, angels contribute mentorship, industry connections, and operational guidance. The term originates from Broadway theatre, where 'angels' would back productions financially.
Venture Capital (VC)
Institutional investment into high-growth startups in exchange for equity. Venture capital firms raise money from limited partners (LP) — pension funds, university endowments, family offices, and sovereign wealth funds — and deploy it into a portfolio of startups expecting a minority of them to generate outsized returns. In India, the VC ecosystem has matured rapidly, with domestic firms (Sequoia Capital India / Peak XV, Accel, Nexus Venture Partners, Blume Ventures) and global investors (Tiger Global, SoftBank, Y Combinator) actively investing across stages from seed to growth. VCs typically take board seats, provide operational support, and help with follow-on fundraising. The typical VC fund lifecycle is 10 years, with returns generated primarily through exits via acquisition or IPO.
Equity
Ownership in a company represented by shares. When an investor provides capital to a startup, they receive equity — a percentage of the company — in return. Equity can be common stock (typically held by founders and employees) or preferred stock (held by investors, with additional rights like liquidation preference and anti-dilution protection). The value of equity is determined by the company's valuation at each funding round. For founders, issuing equity means dilution — each round reduces their percentage ownership — but the goal is to grow the overall pie so that a smaller percentage is worth more in absolute terms.
Dilution
The reduction in a founder's or existing shareholder's ownership percentage that occurs when a company issues new shares to investors, employees (via ESOPs), or other parties. For example, a founder who owns 100% at inception might own 60% after a Series A round that issues 25% of the company to investors and 5% to an ESOP pool and 10% to the existing co-founder pool. While dilution reduces percentage ownership, the goal is that the company's overall value increases enough that the smaller percentage is worth more in absolute terms. Anti-dilution provisions in investor agreements can protect VCs from excessive dilution in down rounds.
ESOP
Employee Stock Ownership Plan — a pool of shares (typically 10–20% of the company) set aside for employees, granting them the right to purchase company stock at a predetermined price (the strike price) after a vesting period. ESOPs are the primary tool Indian startups use to attract and retain talent when they cannot match the salaries offered by larger companies. A typical ESOP structure vests over 4 years with a 1-year cliff (meaning no shares vest in the first year, then 25% vests at the 12-month mark, followed by monthly or quarterly vesting). Upon vesting, the employee can exercise their options — buy the shares at the strike price — and later sell them during a liquidity event like an acquisition or IPO.
Vesting
The schedule by which founders or employees earn their equity over time, typically measured in years of continued service. The standard structure in Indian startups is a 4-year vesting schedule with a 1-year cliff: if someone leaves before the first anniversary, they get zero equity; after the cliff, they have earned 25% of their grant, with the remaining 75% vesting monthly or quarterly over the next three years. Vesting protects the company from granting equity to someone who leaves early and aligns long-term incentives. Founders' shares are also typically subject to vesting, with reverse vesting arrangements that allow the company to buy back unvested shares if a founder departs.
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