Convertible Notes From Private Investors vs a Loan: A Founder's Comparison

In short: A convertible note from private investors is a loan designed to become shares. The investor lends now, interest usually accrues rather than being paid, and the balance converts at a discount or a valuation cap when you next raise equity. It behaves like debt only if no round arrives by maturity. In our illustrative example, a $400,000 note converts into shares worth $672,000 at the next round, while a $400,000 term loan costs $71,438 of interest but $13,095 a month in cash from day one.

Key takeaways

A convertible note has four moving parts: interest, maturity date, discount and valuation cap - and the cap usually decides the price.
In the example, a $400,000 note with 8% interest, a 20% discount and a $4 million cap converts into 112,000 shares worth $672,000 at a $6 million round.
A $400,000 term loan at an illustrative 11% over three years costs $71,438 of interest and no shares, but takes $13,095 a month out of the business.
If no qualifying round happens by maturity, the note is debt: the holder can usually ask for repayment or convert at the cap.
Lenders generally treat an unconverted note as debt, and often want it subordinated before they lend.
An offer of convertible notes is generally an offer of securities, so the disclosure rules and their exemptions matter.

How does a convertible note work?

A convertible note is a loan from an investor to the company that is expected to convert into shares at a later equity round instead of being repaid. Founders use notes to put off agreeing a valuation: the price is set later, by the next investor, with a reward for the note holder for going first. The terms below decide that reward. Ranges shown are indicative only and vary from deal to deal.

Term	What it does	Indicative market practice
Principal	The amount the investor lends	Set by the deal
Interest	Usually accrues and converts with the principal, rather than being paid in cash	Often simple interest in single digits
Maturity date	When the note falls due if it has not converted	Often 12 to 36 months
Discount	The note converts at a discount to the next round's share price	Often 10% to 25%
Valuation cap	The highest company valuation used for conversion, whatever the round's price	Negotiated; the most valuable term to the investor
Qualifying financing	The kind of round that triggers conversion, often with a minimum size	Set by the deal
Maturity and sale options	What happens at maturity or if the company is sold first	Repay, convert at the cap, or extend

Unless the note says otherwise, the holder is an unsecured creditor until conversion. That is the debt side of the instrument, and it matters more than founders expect.

How does conversion work in a worked example?

For illustration: a company with 1,000,000 shares on issue takes a $400,000 note from private investors with 8% simple interest, a 20% discount, a $4.0 million pre-money valuation cap and a 24-month maturity. At month 18 it raises $1.5 million from a new investor at a $6.0 million pre-money valuation, which is $6.00 a share.

Accrued interest: $400,000 at 8% for 1.5 years is $48,000, so $448,000 converts.
Discount price: $6.00 less 20% is $4.80.
Cap price: $4.0 million divided by 1,000,000 shares is $4.00.
The note converts at the lower of the two, $4.00: $448,000 divided by $4.00 is 112,000 shares.

At the round price those 112,000 shares are worth $672,000. The new investor buys 250,000 shares for $1.5 million, so 1,362,000 shares are on issue after the round: the founders hold about 73.4%, the note holder 8.2% and the new investor 18.4%.

Next round's pre-money valuation (illustrative)	Round price	Discount price	Conversion price used	Shares for $448,000
$4.5 million	$4.50	$3.60	$3.60 (discount)	124,444
$6.0 million	$6.00	$4.80	$4.00 (cap)	112,000
$10.0 million	$10.00	$8.00	$4.00 (cap)	112,000

The pattern is the point. When the round is modest, the discount sets the price. When the round is strong, the cap does, and the better your business performs, the larger the note holder's reward: at a $10 million round, the same 112,000 shares are worth $1.12 million.

What does the same money cost as a term loan?

Now borrow the $400,000 instead, at an illustrative 11% over three years, principal and interest monthly. These are examples, not offers.

Measure (illustrative)	Convertible note	Term loan
Cash paid out in the first 18 months	Nil	$235,719 ($13,095 a month)
Interest in the first 18 months	$48,000 accrued, converted to shares	$52,107 paid
Total cost	112,000 shares, worth $672,000 at a $6 million round	$71,438 of interest; $471,438 repaid in all
Ownership given up	8.2% after the round	None
Security	Usually none	General security and often a director's guarantee
If no round happens	$464,000 owed at month 24, or conversion at the cap	Repayments simply continue

The comparison is not "cheap note, dear loan" or the reverse. The loan's cost is lower in dollars - $471,438 of cash against $672,000 of shares - but it has to be paid from cash flow, and a company that can find $13,095 a month during a growth phase is a company that probably does not need a note. The note's cost is paid in ownership and only becomes real if the business succeeds. Measured against selling shares at the round price, the note holder receives 45,333 more shares than $400,000 would have bought at $6.00, a $272,000 premium for taking early risk.

Before deciding, run the loan through the ICR and DSCR calculator to see whether cash earnings can carry it.

When does a convertible note behave like debt?

A note is equity in waiting, but it is debt until it converts. That shows up in three places.

At maturity. If no qualifying round has happened, the note falls due. In the example, $400,000 plus two years at 8% is $464,000. Most notes give the holder a choice - repayment, conversion at the cap (116,000 shares at $4.00) or an extension - and a company without cash is negotiating from weakness.
On a sale. If the company is sold before conversion, many notes pay out a multiple of principal or convert at the cap, whichever the holder prefers.
On insolvency. The holder ranks as a creditor, ahead of shareholders. If the note is secured, it may rank ahead of other creditors too.

Read the maturity clause first. A note that "must" be repaid on demand at maturity, with default interest, is a short-term loan dressed as equity.

How do lenders look at a company with convertible notes?

A bank or non-bank lender reads an unconverted note as debt. Expect four questions:

When does it mature? A note falling due inside the loan term is a refinancing risk, and the lender will want to know how it will be cleared.
Is it secured? A lender taking a general security interest will want any note holder's security released or ranked behind it.
Will the holder subordinate? Most lenders want a deed of subordination so the note is paid only after the loan.
How do the covenants count it? A leverage covenant may include the note as debt until it converts.

Converting or extending notes before you ask for a loan can make the credit story simpler. Our guide to secured and unsecured business loans explains how security ranking shapes what a lender will offer, and our overview of startup finance without property security covers debt options for young companies.

Which rules cover offering convertible notes to private investors?

ASIC administers Chapter 6D of the Corporations Act 2001, which governs fundraising through the issue or sale of securities. An offer of convertible notes is generally an offer of securities, so the same disclosure rules and exemptions as a share offer are relevant - confirm the position for your notes with a lawyer.

ASIC's page on when a disclosure document is needed lists the main exemptions. Personal offers are one: offers to fewer than 20 persons in the previous 12 months, raising no more than $2 million in that period, with no advertising. Offers to people presumed not to need disclosure are another, and a qualified accountant's certificate can show an investor has net assets of at least $2.5 million or gross income of $250,000 or more in each of the previous two years.

Crowd-sourced funding is not a route for notes: business.gov.au's crowdfunding guide describes it as investors receiving ordinary shares.

Note or loan: how do you choose?

If your situation is...	Lean towards	Because
Profitable, steady cash flow, clear use of funds	Term loan	A known cost, no dilution, nothing to convert
Pre-profit, priced round expected within 12 to 18 months	Convertible note	No repayments while you build; the price is set by the next round
Round uncertain, cash thin at maturity	Be careful with either	A note becomes a debt you cannot pay; a loan drains cash now
Buying an asset that could secure a loan	Asset finance or a secured loan	Keeps equity for risks only equity can fund

If you are weighing debt against a note, compare the private investor offer with a loan by posting one loan request on ADS, and 200+ verified lenders and brokers can ask about it.

Frequently asked questions

What is a valuation cap on a convertible note?

It is the highest company valuation used to work out the conversion price, whatever the next round is priced at. In the example, a $4 million cap on a company with 1,000,000 shares gives a $4.00 conversion price, so even if the next round is priced at $10.00 a share, the note converts at $4.00. The cap is usually the most valuable term to the investor.

What happens if a convertible note reaches maturity without a funding round?

It falls due like a loan. Most notes give the holder a choice of repayment, conversion at the cap or an extension. In the example, $400,000 plus two years of 8% interest is $464,000 owed at month 24, or 116,000 shares at the $4.00 cap price. Read the maturity clause before you sign.

Is a convertible note debt or equity?

Both, at different times. Until it converts it is debt: the holder is a creditor and lenders count it as borrowing. After conversion the holder is a shareholder. Its accounting and tax treatment depends on the terms, so ask your accountant how your notes will appear in the financial statements.

Do convertible notes pay interest?

Usually interest accrues and converts into shares with the principal, rather than being paid in cash. That keeps cash in the business, but the accrued interest buys the holder more shares. In the example, 18 months at 8% added $48,000 to the converting amount and 12,000 shares at the $4.00 cap price.

What is a qualifying financing in a convertible note?

It is the kind of equity round that triggers automatic conversion, usually defined by a minimum amount of new money raised from new investors in a priced round. A smaller round below that threshold may not convert the note, leaving it outstanding as debt. Check that the definition matches the round you realistically expect to raise.

Can a company with convertible notes still get a bank loan?

Often yes, but the lender will treat the notes as debt until they convert. Expect questions about the maturity date, any security, and whether note holders will sign a deed of subordination so they are repaid after the lender. Converting or extending notes before you ask for the loan can make the credit decision simpler.

Sources

Corporations Act 2001 (Chapter 6D fundraising) — Federal Register of Legislation
Disclosure documents to be provided to potential investors when raising funds — Australian Securities and Investments Commission
Certificates issued by a qualified accountant (sophisticated investors) — Australian Securities and Investments Commission
Crowdfunding: equity-based crowd-sourced funding and debt-based crowdfunding — business.gov.au

Information current as at 24 October 2026.

General advice warning: This article contains general information only. It does not take into account your objectives, financial situation or needs, and it is not personal credit or financial advice. Consider whether it is appropriate for you and seek advice from a licensed credit representative before acting.

Any interest rate shown is an example only and is not an offer of credit. Where a rate is quoted, the applicable comparison rate is available from the relevant lender and should be considered alongside it.