Convertible Notes in Australia: A Founder's Guide

A convertible note lets a startup take an investor's money now and settle the company's valuation later, usually when a larger funding round prices the business. That is why notes are so common at seed stage. The paperwork is short, the negotiation is quick, and nobody has to agree on what an unproven company is worth.

The catch is that founders do not know how much of the company they have sold until the note converts. A note is also a loan, so it comes with a maturity date, and the way you raise the money is regulated by the Corporations Act even when you never prepare a prospectus.

What this covers

What a convertible note is, and the terms that decide how much of your company you give up
How a note converts into shares, with a worked example using a discount and a valuation cap
The fundraising exemptions Australian startups rely on, and the traps founders fall into

What a convertible note is

A convertible note is a loan that is meant to become shares. The investor hands over money, the company records it as debt, and the debt converts into equity when an agreed event happens. Many investors treat a note as unpriced equity in substance. Their goal is usually to end up with the same preference shares that the company issues to its first big outside investor, a venture capital fund, in a Series A round, not to be repaid with interest. Series A is the name for that first large round. Preference shares are a class of shares that are paid out ahead of ordinary shares (the standard shares founders usually hold) if the company is sold or wound up.

For tax and accounting purposes, though, a note is debt. It typically ranks ahead of shareholders, meaning it is repaid before them if the company fails, and level with other unsecured debt. It is almost always unsecured, meaning the investor has no claim over particular company assets, because documenting and registering security over a seed-stage startup's thin assets costs more than it is worth to the investor. Holders usually have few rights beyond a creditor's claim to principal and interest and the right to receive shares when the note converts.

A note differs from an ordinary convertible loan in form. A convertible loan is a loan or facility agreement with a small group of lenders. A convertible note is issued as a security that can be transferred, and it is designed to be offered to a wider group of investors whose holdings are recorded on a register, much like shareholders.

When a convertible note makes sense

Notes suit companies raising a modest amount early, where a valuation would be mostly guesswork. The practical advantages are:

Familiarity. Notes have been one of the most popular seed instruments, so most seed investors already know how they work.
Simplicity and cost. Note documents are short and have relatively few negotiated terms, and they are easy to explain to investors who are new to startups. A priced round, where the investors and founders agree a valuation and issue shares at a set price, needs longer and more complex equity documents.
No valuation fight. The price is set later by reference to the next round.
Employee equity. Issuing notes typically has little effect on the fair market value of your ordinary shares, which keeps employee equity incentives attractive.

The trade-off is uncertainty. If the business does well, the notes convert at a discount to what new investors pay, so founders can give up more than they would have in a priced round at the start. A note with a $5 million valuation cap is not the same thing as selling shares at a $5 million valuation, and founders are often surprised by how much dilution they end up with. Dilution means your percentage ownership shrinks as new shares are issued.

If you are earlier than a note, or weighing it against other options, our guide to seed funding in Australia covers the wider choices.

The key terms of a convertible note

Experienced angel investors focus on the terms that set the conversion price, because they affect returns far more than the interest rate on a short-term note. These are the terms to understand before you sign.

Principal. The amount the investor puts in, also called the face value. Seed note rounds commonly run from tens of thousands of dollars to more than $1 million in total.
Interest. Interest accrues each year on the principal. It is either added to the principal when the note converts or paid to the investor in cash.
Maturity date. Usually one to two years after issue. At maturity the note becomes payable on demand. Companies prefer a structure where repayment can be demanded only by a majority of the noteholders, so no single holder can force the issue.
Discount. A reduction on the price new investors pay in the next round, typically around 20 to 25 per cent. It rewards early investors for taking more risk than the people who come in later.
Valuation cap. A ceiling on the pre-money valuation (the company's value before the new investment is added) at which the notes convert. Market guidance puts seed-stage caps at roughly $3 to 5 million at the lower end and $8 to 10 million at the higher end. Treat that as a guide to the market, not a rule, and expect it to move with the quality of the business and the amount raised.

Where a note has both a discount and a cap, it converts at whichever gives the lower price per share, so the investor gets the better of the two.

Some note deeds also restrict what the company can do while the notes are outstanding. Typical examples are paying dividends, restructuring capital, or issuing other debt that ranks ahead of the notes without the noteholders' written consent. Read these carefully, because they limit what you can do before the notes convert.

How a convertible note converts into shares

A note converts when one of three things happens.

A qualifying financing. This is the usual trigger. It is a funding round that meets the conditions set in the note. The company raises new money in a priced round, often a Series A preference share round, above a minimum amount that is often $1 million. The principal and interest convert into the same class of shares the new investors buy, but at the note's conversion price rather than the price the new investors pay. Check how the minimum is defined. Some deals count the note money itself towards it, which weakens the test when the company has already raised $500,000 or more on notes.

A sale of the company. If the company is sold while notes are outstanding, noteholders can usually choose between cash and shares. The cash is their principal and interest, sometimes with a multiple of the principal on top. The shares are ordinary shares at a discount to the price the buyer pays, or at the price implied by the cap.

Maturity. If the note reaches its maturity date without either of those events, the investor commonly has a choice. They can convert into ordinary shares at a set price, or leave the note outstanding so it keeps accruing interest and can still convert in a later round or sale. Investors rarely choose ordinary shares without a transaction. Holding debt while waiting for the chance to get preference shares in a future round is a better position than holding ordinary shares next to the founders.

A worked example

Assume the company has 10 million fully diluted shares before its Series A. Fully diluted means every share that exists plus every share that could be issued, here 9 million issued shares and 1 million shares set aside in an option pool for employee options. It has $500,000 of notes outstanding, counting interest, with a 25 per cent discount and a $4 million valuation cap. The Series A investors pay $0.70 per share, which implies a $7 million pre-money valuation.

The discount price is $0.70 less 25 per cent, which is about $0.53 per share.
The cap price is $4 million divided by 10 million shares, which is $0.40 per share.
The notes convert at the lower price, $0.40, so the noteholders receive 1,250,000 shares.

At the Series A price, the same $500,000 would buy about 714,000 shares. The cap gives the noteholders roughly 536,000 more, and every one of those extra shares comes out of the founders' and other shareholders' position. This is the dilution that surprises founders.

What happens if the notes have not converted by maturity

If no qualifying financing has happened by the maturity date, the notes are due. A company that has spent the money building the business rarely has the cash to repay them.

The legal position depends on the drafting. In many note deeds, a failure to repay at maturity is not a default unless the required noteholders formally demand payment, and in practice notes are often left outstanding long past their original maturity date. The risk is that an investor can use the maturity date as bargaining power. Founders asking for an extension may be asked to give up more equity in exchange, and even a friendly extension costs legal fees to document.

Raising money lawfully: disclosure and exemptions

Notes are securities. Under the fundraising provisions of the Corporations Act, any offer to issue securities needs a disclosure document, such as a prospectus (a formal regulated document describing the offer and the company), unless an exemption applies. Preparing one is expensive and slow, so seed-stage startups structure their note rounds to fit an exemption.

Proprietary companies (companies with Pty Ltd after their name) are also restricted in what they can do. A proprietary company cannot engage in fundraising that would need disclosure, other than offers to its existing shareholders or employees. In practice that means a proprietary company needs an exemption for every note offer it makes to outside investors.

The exemptions startups most often use are these.

Small-scale personal offers. A personal offer can be accepted only by the person it is made to, and it is made to someone likely to be interested because of previous contact, a professional connection, or something they have said or done that shows interest in offers of that kind. The exemption allows issues to no more than 20 investors and no more than $2 million in any 12 months. Investors who are covered by other exemptions are left out of the count.
Sophisticated investors. The exemption applies where the minimum amount payable on acceptance is at least $500,000 (counting what the investor has already paid for securities of the same class), or where a qualified accountant's certificate shows the investor has net assets of at least $2.5 million or gross income of at least $250,000 in each of the last two financial years, or where a licensed financial services provider is satisfied the investor has enough investing experience to assess the offer. Two traps are worth knowing. First, the courts have confirmed that the $500,000 test looks at the minimum the offer requires, so an offer that lets people invest $1,000 does not qualify just because one investor happens to put in more. Second, money the investor borrows from the company or an associate to fund the investment does not count towards the amount.
Professional investors. This covers licensed financial services providers, regulated and listed entities, and anyone who has or controls gross assets of at least $10 million.
Senior managers and their families. This covers people involved in managing the company, their spouses, parents, children, brothers and sisters, and companies they control. It is the usual route for friends and family rounds.

Crowd-sourced funding is a separate regime. It allows an eligible company to raise up to $5 million in a 12-month period, with each investor limited to $10,000 in that period, through a licensed online platform. It leaves the company with a large register of unsophisticated shareholders, and most early-stage companies treat it as a last resort.

An exemption from disclosure is not an exemption from accuracy. The Corporations Act prohibits misleading or deceptive conduct in connection with fundraising and financial products, and that applies whether or not you prepare a disclosure document. Investors in a seed note round usually see only a one-page summary, a pitch deck and a term sheet, and every one of those has to be accurate. Be particularly careful with forecasts and financial projections, which attract close attention from ASIC, the corporate regulator.

Tax and accounting

Notes are treated as debt for tax and accounting purposes, even though investors see them as deferred equity. The detail depends on how the note is structured and on the company's circumstances, so get tax and accounting advice before you choose an instrument.

Simple agreements for future equity (SAFEs) are treated differently. A SAFE is a contract where an investor pays money now and receives shares in a later funding round, without it being structured as a loan. Under the venture capital and income tax legislation, a SAFE can be an eligible venture capital investment if it is a convertible security that is not a debt interest, which can make it more attractive than a note in some situations. How SAFEs are taxed is still an area of uncertainty in the market.

Traps founders fall into

Not knowing what you have sold. Neither founders nor investors know the ownership split when notes are signed. Model the conversion at several Series A prices before you agree to a cap, so the dilution is not a surprise.
Phantom liquidation preference. Noteholders can end up with a right to be paid first in a sale that is worth more than the money they put in. It is easy to miss, so it has its own explanation below.
Unclear cap wording. State expressly that the cap is based on the pre-money valuation of the qualifying financing. A vague reference to a cap on valuation invites an argument later that a post-money figure was intended.
The maturity date. Set it with the company's realistic fundraising timeline in mind, and prefer majority-of-noteholder control over repayment demands.
Series A investors reopening the notes. A new investor who dislikes the economics of the conversion can make renegotiating the notes a condition of investing, and that happens at the point when you most need the round to close.
Weak rounds. If the company later has to raise on poor terms, a large issue of shares at a low price can dilute founders, employees and other shareholders heavily. Investors with anti-dilution protection can push that cost onto founders.

Notes also sit alongside the rest of your cap table, which is the record of who owns what share of the company. A shareholders agreement and founder share vesting are worth having in place before investors review the company.

Phantom liquidation preference in plain English

This trap catches many founders out, and the terms are not self-explanatory, so here is the idea step by step.

Liquidation preference. When a company is sold or wound up, the money does not go to every shareholder equally. Holders of preference shares are paid first, up to a fixed amount per share, and ordinary shareholders (usually the founders) share whatever is left. That fixed amount is the liquidation preference. For Series A shares it is normally the price paid per share, so an investor who pays $0.70 a share is entitled to $0.70 per share back before the founders receive anything.

Where the problem comes from. Noteholders convert at a cheaper price than the Series A investors, so they receive more shares for their money. Their shares are the same class as the Series A shares, though, so each one carries the same $0.70 preference even though the noteholders paid less per share. Using the worked example above:

The noteholders put in $500,000 and convert at $0.40 per share, so they receive 1,250,000 shares.
Each of those shares carries a $0.70 liquidation preference, so the noteholders are entitled to $875,000 ahead of the founders (1,250,000 shares multiplied by $0.70).
That is 1.75 times the money they invested. The extra $375,000 is the "phantom" preference. Nobody negotiated for it, and it is a by-product of how the conversion works.

The lower the cap, the bigger the gap. At a $2 million cap, the same $500,000 would convert at $0.20 per share into 2.5 million shares, which carry a preference of $1.75 million, or 3.5 times the money invested.

Anti-dilution protection. This is a term that protects an investor from having their stake watered down if the company later sells shares at a lower price. A full ratchet is the strongest common version, because it resets the investor's price to match the new, lower price. Plain notes can leave the noteholders in a position that is even better than that, which would be well outside market in a seed equity round.

The fix. Instead of converting into the same shares as the Series A investors, the notes convert into a separate series, often called a shadow series. It is identical to the Series A shares in every respect except one. The liquidation preference per share is set to what the noteholders paid, here $0.40. Their preference then comes to $500,000, which is exactly their money back, and the founders are not carrying a preference nobody agreed to.

When to raise it. It matters most when the cap is at the lower end of the usual range and the amount raised is at the higher end, since both widen the gap. If that describes your round, ask your lawyer about a shadow series before you sign the notes.

Common questions

Is a convertible note debt or equity?

It is debt that can turn into equity. It is treated as debt for tax and accounting, and the noteholder is a creditor until conversion. Many investors view it as deferred equity.

Do I need a prospectus to issue a convertible note?

Not if you rely on an exemption, such as a small-scale personal offer, a sophisticated or professional investor, or an offer to senior managers and their families. You still need to make sure your pitch materials are accurate and not misleading.

Which is better for a startup, a convertible note or a SAFE?

Neither is better in every case. A SAFE has no maturity date and may be treated differently for tax, and SAFEs are more common where the company has more negotiating power than its investors. Both can produce conversion outcomes that are less favourable to founders than they expected, so model the numbers for each.

What is a typical discount and valuation cap?

Market guidance suggests a discount of around 20 to 25 per cent, and a seed-stage cap of roughly $3 to 5 million at the lower end and $8 to 10 million at the higher end. Your own terms depend on the company, the investors and the amount raised.

Key takeaways

A convertible note is a loan that converts into shares, usually at the next priced funding round, and it is treated as debt for tax and accounting purposes.
Notes are quick and cheap to document, but founders do not know how much of the company they have sold until conversion.
Notes convert at the lower of the discount price and the cap price, so a low cap or a large discount can mean much more dilution than a priced round would have caused.
If notes have not converted by maturity, investors can demand repayment or use the date as bargaining power for more equity.
Most seed note rounds rely on a prospectus exemption. Check the limits of each one, and keep your pitch materials accurate regardless.
Watch for phantom liquidation preference, unclear cap wording and Series A investors reopening the terms.

Raising a seed round and weighing a convertible note against other options? Talk to Plumlaw about a fixed-fee review of your note terms and fundraising structure before you sign.

Convertible Notes in Australia: What Founders Need to Know Before They Raise