Convertible Note
Understand how a convertible note works, the key terms involved, and when it makes sense for Australian startups to use one.
Written by: Mark Lazarus, Commercial Lawyer, Director of Lazarus Legal
Published: 26 February 2026
Legal Disclaimer: The information on this page is general in nature and is not intended to constitute legal advice. It does not take into account your personal circumstances. Laws and legal processes can change, and their application varies between cases. You should seek independent legal advice before acting on any information on this page.
What Is A Convertible Note?
A convertible note is a short-term debt instrument that allows investors to lend money to a startup, with the understanding that the loan will convert into shares rather than be repaid in cash.
At its core, it works like a loan. The startup borrows money, accrues interest, and agrees to repay it. But instead of a cash repayment, the debt converts into equity when a triggering event occurs, typically a future funding round.
Startups use convertible notes because pricing equity early is difficult. In the earliest stages, there is often no reliable basis for a valuation. A convertible loan note lets both parties sidestep that negotiation and revisit it when there is more data to work with.
How Does A Convertible Note Work?
Understanding how a convertible note works requires looking at three stages: when it is issued, how interest accrues during its term, and what triggers conversion into equity.
Issuance
The process begins when an investor agrees to lend money to a startup. The company then issues a convertible note agreement setting out the commercial terms, including the principal amount, interest rate, maturity date and conversion mechanics. Both parties sign the agreement before funds are transferred.
At this stage, no shares are issued. The investor holds debt, not equity.
Interest Accrual
Once issued, interest accrues on the principal in accordance with the agreement. Most convertible notes use simple interest, although some provide for compounding. In Australia, rates commonly range between 5% and 12% per annum, depending on risk and negotiation.
The note typically matures within 12 to 24 months. If no conversion event has occurred by that date, the company must repay the principal and accrued interest, extend the note by agreement, or renegotiate the terms. Failure to do so may place the company in default.
Conversion Trigger
Convertible notes are usually intended to convert rather than be repaid. Conversion most commonly occurs when the company completes a qualified financing round above a minimum threshold specified in the agreement.
At conversion, investors typically receive shares at a discount to the new round price and may also benefit from a valuation cap, which sets a maximum conversion valuation. Most agreements provide for automatic conversion on a qualifying round, although some allow investor election or conversion on a sale or IPO. Together, the discount and valuation cap reward early risk and can provide more favourable pricing than later investors receive.
Key Terms in a Convertible Note
Every convertible note agreement contains a set of defined terms that determine how the investment works in practice. Understanding these before you sign protects both founders and investors from disputes down the track.
- Principal amount: The dollar amount the investor lends to the company.
- Interest rate: The annual rate at which interest accrues on the outstanding principal.
- Maturity date: The date by which the note must convert, be repaid, or be extended.
- Discount rate: The percentage reduction applied to the conversion price compared to the next round's share price.
- Valuation cap: The maximum pre-money valuation used to calculate the conversion price, regardless of the actual round valuation.
- Qualified financing: A future funding round that meets a minimum threshold, triggering automatic conversion.
- Conversion mechanics: The formula used to calculate how many shares the noteholder receives on conversion.
- Default provisions: What happens if the company fails to convert, repay, or extend by maturity
- Repayment rights: Whether the investor can demand cash repayment in certain circumstances, such as a sale or insolvency.
Convertible Notes VS SAFE Agreements
Both convertible notes and SAFE agreements are used by Australian startups to raise early-stage capital without pricing equity upfront. They share a similar purpose but differ significantly in legal structure, investor protections, and risk allocation.
| Feature | Convertible Note | SAFE |
|---|---|---|
| Legal nature | Debt instrument | Equity-like instrument, not debt |
| Interest | Yes, accrues over time | No interest |
| Maturity date | Yes, repayment or conversion required by set date | No maturity date |
| Repayment risk | Yes, investor can demand repayment at maturity | No repayment obligation |
| Complexity | Moderate to high | Generally simpler |
| Common use in Australia | Widely used, well understood by investors | Growing adoption, less standardised than in the US |
A convertible note suits situations where investors expect a clear return timeline and want the protection of debt. The maturity date and repayment rights give investors leverage that a SAFE does not.
A SAFE (Simple Agreement for Future Equity) is a lighter instrument with no debt obligations. It works well when both parties want speed and simplicity and the investor is comfortable without a maturity backstop. SAFEs are increasingly used in Australia but lack the standardisation they have in the US market. Some Australian investors still prefer the legal familiarity of a convertible note agreement.
Pros And Cons For Australian Startups
Convertible notes offer genuine advantages for early-stage fundraising, but they are not without risk. Founders should weigh both sides before deciding whether this structure fits their current stage and capital strategy.
Pros Of A Convertible Note
- Defers valuation: Avoids the need to negotiate a company valuation before meaningful traction data exists.
- Faster to execute: A convertible note agreement is typically quicker to negotiate and close than a priced equity round.
- Useful for bridge funding: Effective tool for raising capital between rounds without resetting the cap table.
- Attractive to sophisticated investors: Well-understood structure with established protections that experienced angel investors and early-stage funds are comfortable with.
Cons Of A Convertible Note
- Debt on the balance sheet: Unlike equity, a convertible note sits as a liability until conversion occurs, which can affect the company's financial position.
- Repayment risk at maturity: If a qualifying round does not close before the maturity date, the company may face pressure to repay or renegotiate.
- Complications in later rounds: Future investors may scrutinise outstanding notes carefully. Unclear terms or high caps can create friction during a Series A process.
- Dilution surprises: Founders sometimes underestimate the dilutive impact of valuation caps, particularly if the company raises at a high valuation in the next round.
The Australian Regulatory Context
Convertible notes sit at the intersection of corporate and tax law. Before issuing one, startups should understand the disclosure rules under the Corporations Act and the potential tax consequences of the structure adopted.
ASIC Considerations
Issuing a convertible note involves securities law obligations under the Corporations Act 2001 (Cth). As a general rule, offering securities in Australia requires a disclosure document such as a prospectus.
Early-stage startups commonly rely on exemptions in section 708. The most relevant is the sophisticated investor exemption, which applies where the investor has net assets of at least $2.5 million or gross income of at least $250,000 per year for the past two financial years, certified by a qualified accountant. Professional investors, such as licensed financial institutions and wholesale funds, may also qualify under separate exemptions.
If investors do not meet these thresholds, formal disclosure may be required. Non-compliance can expose the company and its directors to significant liability.
ATO Treatment
The tax treatment of a convertible note depends on its legal and commercial substance. Interest on a genuine debt instrument may be deductible, but the ATO will examine whether the arrangement is in substance more equity than debt.
On conversion, the investor is generally treated as disposing of the debt and acquiring shares, which may have CGT implications depending on the conversion terms and cost base. Non arm’s length arrangements increase the risk of reclassification.
Not all convertible notes are treated the same for tax purposes. Careful structuring is critical.
When Should You Use A Convertible Note?
A convertible note is not the right instrument for every funding situation. It works best in specific circumstances.
Bridge rounds between Seed and Series A
When a startup has a clear path to a priced round but needs capital to reach the next milestone, a convertible note avoids the cost and time of running a full equity process.
When valuation is uncertain
If the company lacks the revenue, traction, or comparable data to justify a defensible valuation, deferring that conversation through a note makes commercial sense for both parties.
When speed matters
Closing a priced round typically takes months. A well-drafted convertible note can close in weeks, which matters when timing is critical.
When raising from sophisticated investors
Experienced angels and early-stage funds often prefer the familiar structure of a convertible note. It signals that the founding team understands how institutional capital works.
Convertible notes are less suitable for large raises where investor rights and governance become more significant, or where investors are not legally sophisticated and may not fully understand the conversion mechanics.
Getting Legal Advice
While convertible note templates are widely available online, using them without legal review can be costly.
Standard terms such as valuation caps and qualified financing thresholds can significantly affect dilution, investor rights and founder control. If disclosure exemptions under the Corporations Act are misunderstood or poorly documented, the company may face regulatory exposure.
Convertible notes should also align with your Series A plans, as new investors will scrutinise existing terms closely. A brief review by an experienced contract lawyer can help ensure the note supports, rather than complicates, your next funding round.
Summary
- A convertible note is a short-term debt instrument that converts into equity at a future funding round rather than being repaid in cash.
- Key conversion terms include the discount rate and valuation cap, both of which give early investors an advantage over later-stage investors.
- Interest accrues during the note’s term, typically at 5% to 12% per annum, with a maturity date of 12 to 24 months.
- If no conversion event occurs by maturity, the company must repay, extend, or renegotiate, creating real financial risk.
- Convertible notes sit as debt on the balance sheet until conversion, unlike SAFEs, which carry no repayment obligation.
- Australian startups issuing convertible notes must comply with the Corporations Act 2001, including Section 708 disclosure exemptions.
- The ATO treats convertible notes as debt instruments, but structure affects interest deductibility and CGT outcomes on conversion.
- Templates carry risk. Poorly drafted terms can create dilution surprises, investor disputes, and complications in future funding rounds.
- Legal advice before issuing a convertible note is not optional. It is part of protecting your cap table and your next raise.
About Mark Lazarus – Director, Lazarus Legal
Admitted in both Australia and the UK, Mark brings more than two decades of global legal experience to Lazarus Legal. Having worked as a barrister, in private practice, and as in-house counsel for a major international consumer brand he combines courtroom-honed advocacy with commercial insight. Specialising in commercial law, intellectual property and dispute resolution, Mark advises startups, creative businesses, and established enterprises on transactions, trademarks, contract drafting, and litigation strategy. His cross-jurisdictional background and history as a former in-house legal director give clients confidence that their legal issues will be managed with both strategic foresight and commercial realism.