Convertible Notes: How They Work for Australian Startups

If you’re raising money for your startup or growing small business, you’ve probably heard investors mention “convertible notes” as a fast, flexible way to invest.

But what is a convertible note in practice, and how does it actually work under Australian law?

A convertible note can be a helpful funding tool when you’re not ready to lock in a company valuation (or you want to move quickly), but it’s still a legal contract that needs careful drafting. The “simple” versions you find online often miss key protections, and that can create expensive disputes later - especially when you hit a funding round, a maturity date, or a sale of the business.

This article is general information only and isn’t legal or financial advice. Because the right structure and terms depend on your company, your investors, and the way the note is drafted, it’s worth getting advice before you take money from anyone.

Below, we’ll break down what a convertible note is, how it works, the key terms you’ll see in Australia, and the legal documents you should have in place before you accept investment funds.

What Is A Convertible Note (And Why Do Startups Use Them)?

So, what is a convertible note?

A convertible note is a funding arrangement where an investor provides money to your company as a loan, and instead of being repaid in cash like a standard loan, the amount can convert into shares later (most commonly when you raise a priced equity round, depending on the note terms).

In plain English: it’s a loan now that often becomes equity later.

Startups and high-growth businesses often use convertible notes because:

• They can be faster than negotiating a full share subscription and shareholders’ terms for a first raise.
• They can delay valuation discussions until you’ve built more traction (revenue, customers, product progress).
• They can align early investors with later investors by using conversion mechanics like a discount or valuation cap.

That said, it’s important to remember a convertible note is still a legal and financial commitment. Unless the note is drafted so that conversion is the only outcome, if conversion doesn’t happen the note may be repayable, and directors need to consider the company’s ability to meet those obligations.

If you’re documenting a raise, it’s worth getting the Convertible Note terms right from the start so you know exactly what happens at conversion, maturity, and exit.

How Does A Convertible Note Work In Australia?

Convertible notes can be structured in different ways, but most follow the same overall lifecycle.

1) You Receive Funds Now (As A Loan)

The investor pays money to your company.

Legally, this is usually treated as a debt owed by the company to the investor (subject to the terms of the note).

2) Interest Accrues (Often, But Not Always)

Many convertible notes include an interest rate. Instead of being paid monthly, interest is commonly added to the amount that converts into shares later (this is sometimes called “capitalised” interest).

Even if the interest rate is low, it’s still part of the deal, and it can affect your cap table when the note converts.

3) A “Conversion Event” Happens

The note typically converts when a defined event occurs, such as:

• A priced equity raise (e.g. a seed round with a valuation)
• An exit (for example, a sale of shares, sale of the business/assets, or an IPO - depending on how “exit” is defined in the note)
• A maturity date (more on this below)

At conversion, the investor receives shares, usually on favourable terms compared to new investors (for taking early risk) - but the exact outcome depends on the conversion formula and the drafting.

4) Shares Are Issued And Your Company Records Are Updated

When the conversion occurs, your company will need to properly issue shares and update its records (and in some cases, lodge updates with ASIC).

This is one reason it’s important your company’s governance documents are in good shape - for example, having a clear Company Constitution can make it easier to manage share issues, rights, and decision-making when new investors come on board.

Key Convertible Note Terms You Need To Understand

Convertible notes feel “standard” in the startup world, but the details matter. Here are the main terms you’ll want to understand before you accept any funds.

Investment Amount (Principal)

This is the amount invested (the loan amount). If multiple investors invest, make sure the document deals clearly with multiple notes and how they interact.

Discount Rate

A discount gives noteholders the right to convert into shares at a cheaper price than new equity investors in the next round.

For example, if the next round price is $1.00 per share and the note has a 20% discount, the note might convert at $0.80 per share (subject to the drafting).

Valuation Cap

A valuation cap sets a maximum valuation for calculating the conversion price, regardless of how high the next round valuation is.

This can reward early investors if the company grows quickly between the note and the priced round.

From a founder’s perspective, caps can be useful to close a deal, but they can also lead to more dilution than you expect. It’s worth modelling scenarios before you sign anything.

Interest Rate

As mentioned, interest often accrues and converts into shares rather than being paid in cash. The note should spell out:

• the interest rate
• when it starts accruing
• whether it compounds
• how it’s treated on conversion or repayment

Maturity Date (And What Happens If You Don’t Raise)

The maturity date is effectively the deadline. If no conversion event happens by that date, the note terms decide what happens next.

Common options include:

• Repayment (the company must repay the principal plus interest)
• Automatic conversion (e.g. converting at a pre-agreed valuation or formula)
• Investor choice to convert or request repayment
• Extension by agreement

This is one of the biggest “hidden risk” areas for founders. A note can feel like equity, but if maturity arrives and you haven’t raised a round, it can behave like a loan - unless the note is drafted so that repayment isn’t available (which is not always the case).

Conversion Mechanics (How The Share Price Is Calculated)

Your note should be crystal clear on the conversion price formula. Ambiguity here is a common cause of disputes between founders and investors, especially where there’s both a discount and a valuation cap and it’s not clear which applies first (or whether the investor gets the better of the two outcomes).

Events Of Default

Convertible notes often include “default” triggers (for example, insolvency events). This can give investors rights to enforce repayment or take other action. You’ll want to understand these clauses, because they can impact your company’s ability to trade through tough periods.

Convertible Notes Vs Equity: Which Makes More Sense For Your Business?

Convertible notes aren’t automatically “better” than issuing shares. The best option depends on where your business is at, your investor profile, and how soon you expect to raise a priced round.

When A Convertible Note Can Make Sense

• You’re early-stage and valuation would be difficult or time-consuming to negotiate.
• You need to move quickly (but still want a written agreement that’s commercially sensible).
• You expect a priced round soon (so the note will convert before maturity becomes an issue).
• You want to keep legal costs proportionate while still documenting the deal properly.

When Equity May Be The Better Fit

• You’re ready to set a valuation and want certainty on dilution now.
• The investor wants immediate shareholder rights (e.g. voting, information rights) and you’re comfortable negotiating those upfront.
• You don’t want debt sitting on the balance sheet or the pressure of a maturity date.

Even when you use a convertible note, it’s common for investors (or co-founders) to ask for clarity around governance and decision-making. If there are multiple founders, a tailored Shareholders Agreement can help prevent misunderstandings about control, future fundraising, and exits.

What Legal Documents And Compliance Issues Should You Consider?

Funding isn’t just a commercial decision - it has legal and compliance layers too. Getting the paperwork right early tends to save time and stress later (especially when your next investors run due diligence).

The Core Documents You’ll Usually Need

• Convertible note agreement: This sets out the investment amount, conversion mechanics, maturity, interest, default, and any investor rights.
• Company governance documents: A clear Company Constitution can be important for issuing shares, setting share classes (if needed), and handling director/shareholder decisions.
• Shareholder arrangements (where relevant): If you already have multiple owners, a Shareholders Agreement can clarify who controls what, how you approve new share issues, and what happens if someone exits.
• Term sheet (optional but common): A short document outlining the main commercial terms before moving to full legal docs. If you’re putting a roadmap in writing, a Term Sheet can be a practical first step.

Fundraising Compliance (Don’t Skip This)

In Australia, raising money (including via convertible notes) can trigger rules under the Corporations Act, including restrictions on offering investments to the public without appropriate disclosure.

Many early-stage raises rely on exceptions or exemptions (for example, based on who the investors are or how the offer is made), but whether you can rely on an exemption depends on the facts. You shouldn’t assume you’re automatically exempt just because you’re a startup, or because you’re only raising “a small amount.”

It’s also important to consider what you’re saying to investors. If you’re providing forecasts, describing your product, or making statements about future returns, you need to be careful to avoid misleading or deceptive conduct and to keep investor communications consistent with the legal documents.

If you’re unsure where your raise sits, it can help to speak with a lawyer early or start with a structured capital raising consult so you know what fundraising pathway fits your business.

Due Diligence: Think About The Next Round Now

Many founders think a convertible note is “just something to get you through to the seed round.” But seed investors will usually review the earlier note terms closely.

If your note has unusual conversion rights, unclear valuation cap mechanics, or investor veto rights that don’t align with market norms, it can slow down (or even derail) your next raise.

A well-drafted note should make the company investable, not harder to invest in.

Common Mistakes Founders Make With Convertible Notes (And How To Avoid Them)

Convertible notes are common, but founders often run into trouble for the same reasons - usually because the parties assumed everyone had the same understanding, and then the business grew faster (or slower) than expected.

1) Treating The Note Like “Friendly Money”

Even if your investor is a friend, family member, or a supportive early backer, the document needs to be clear.

If the relationship sours later, it’s the written agreement (and your company records) that will matter.

2) Not Modelling Dilution Properly

Discounts and valuation caps can significantly change how many shares the investor receives.

Before signing, it’s worth modelling a few scenarios:

• a “great” next round (high valuation)
• a “normal” next round (moderate valuation)
• a delayed raise (maturity date approaching)

This helps you understand what you’re really giving away, and it can also help you negotiate terms confidently.

3) Leaving Maturity Date Outcomes Vague

If maturity arrives and there’s no priced round, you don’t want a panic negotiation with investors while you’re already under pressure.

Your note should clearly spell out whether the company must repay, whether investors can force repayment, whether conversion happens automatically, or whether there’s another agreed mechanism.

4) Accidentally Creating “Side Deals” In Emails

Founders often negotiate informally over email or chat, then sign a short-form agreement that doesn’t match those messages.

Try to keep all final terms in one document, and be careful about promises like “we’ll definitely extend maturity if needed” or “you’ll get the best price no matter what.” If it’s not in the note, it can create misunderstanding (or disputes) later.

5) Forgetting The Company Housekeeping

When the note converts, you need to be able to issue shares properly and update your records. If your cap table is messy or your governance documents are unclear, your legal and admin workload can explode right when you’re trying to close a funding round.

Putting the right foundations in place early - including shareholder arrangements, board approvals, and consistent records - makes fundraising smoother.

Key Takeaways

• What is a convertible note? It’s typically a loan to your company that can convert into shares later, most commonly at the next priced funding round (depending on the terms).
• Convertible notes are popular with Australian startups because they can be quicker to negotiate and can delay valuation until the business has more traction.
• Key terms to understand include the discount rate, valuation cap, interest rate, maturity date, conversion events, and what happens if you don’t raise before maturity.
• Convertible notes can still behave like debt, so you should be confident your company can manage maturity and any repayment outcomes if conversion doesn’t happen.
• Good documentation matters - a clear convertible note agreement, solid governance documents, and (where relevant) a Shareholders Agreement can help avoid disputes and make your next fundraising round smoother.
• Fundraising in Australia can trigger compliance obligations under the Corporations Act, so it’s worth checking your position early rather than relying on assumptions.

If you’d like help putting a convertible note in place (or reviewing one an investor has sent you), you can reach us at 1800 730 617 or team@sprintlaw.com.au for a free, no-obligations chat.