What Do I Need To Know About Convertible Notes?

Raising capital is a big milestone for any startup, but negotiating valuation early can be tricky. That’s where convertible notes come in - a flexible way to bring in funding now, and convert that investment into shares later when your valuation is clearer.

If you’re exploring seed or bridge funding in Australia, understanding how convertible notes work - and the legal boxes you need to tick - will help you raise money confidently and protect your company for the long term.

In this guide, we’ll break down the essentials in plain English, highlight the key terms investors care about, and outline the steps to issue notes the right way.

What Is A Convertible Note (In Australia)?

A convertible note is a short-term debt instrument that converts into equity (shares) on agreed terms. Instead of valuing your company today, the investor lends money now and receives shares later - usually when you next raise a “priced” round.

Think of it as a bridge between where you are and your next equity raise. It can be quicker to negotiate and avoids difficult valuation debates at the earliest stage.

In practice, the deal is documented in a dedicated Convertible Note agreement (or deed) that sets out when and how the note converts, the discount or valuation cap, interest, maturity, and investor protections.

How Do Convertible Notes Work?

Every note is slightly different, but most follow a similar logic:

• Investment now, conversion later: Your company receives funds today. The investor’s “loan” converts into shares on a trigger event.
• Typical conversion trigger: A qualified equity round above a set minimum (e.g. your next Series Seed or Series A), a sale of the company, or on maturity if agreed.
• Discount and/or valuation cap: To reward early risk, investors usually convert at a discount to the next round price, or at a capped valuation - whichever gives them the better price per share.
• Interest: Interest may accrue (simple or compounding) and either pays in cash or converts into shares with the principal.
• Maturity date: If there’s no qualifying round by a set date, the note may repay, auto-convert at a pre-agreed mechanism, or allow the investor to choose.

SAFE notes are another popular option. Unlike a note, a SAFE is not debt and typically has no interest or maturity date. If you’re weighing up the differences, have a look at the SAFE Note option many Australian startups use at pre-seed and seed.

Key Terms You’ll See In A Convertible Note

While every raise is unique, these terms appear in most Australian convertible notes:

1) Conversion Triggers

• Qualified financing: A new equity round above a set threshold (e.g. $1m).
• Liquidity event: Sale of the company or IPO, often with a choice to convert or receive a return multiple.
• Maturity: If no round by a certain date (12-24 months is common), the note may repay or convert at a formula.

2) Valuation Cap

The cap sets the maximum company valuation used to calculate the conversion price. If your next round values the company above the cap, the investor benefits from the lower capped valuation when converting.

3) Discount

A percentage reduction (e.g. 15-25%) applied to the next round price per share. If there’s both a cap and a discount, conversion often uses whichever yields the lower price per share for the investor.

4) Interest Rate

Some notes accrue interest (5-10% is common), which typically converts into shares alongside principal. Others are “zero-interest” to keep cap table outcomes simpler.

5) Maturity Date

Sets a backstop. On maturity, the note might repay, auto-convert at a pre-agreed valuation or formula, or give investors an election. Think carefully about cash flow before agreeing to mandatory repayment.

6) Most Favoured Nation (MFN)

An MFN clause gives the investor the benefit of more favourable terms you later offer to other note investors. This is common in rolling note rounds.

7) Security, Subordination And Ranking

Most early-stage notes are unsecured and rank behind bank debt. Some investors may ask for a security interest. If you grant security, be aware of enforcement rights and priority in a downside scenario.

8) Investor Protections

These can include information rights, negative covenants (e.g. a limit on additional debt), and consent rights for major actions. Keep these proportionate so you maintain operating flexibility.

What Laws And Compliance Issues Should I Consider?

Convertible notes are a form of fundraising, so you need to comply with Australian financial services and company law. Key areas include:

Fundraising Without A Prospectus

Most early-stage raises rely on disclosure exemptions under the Corporations Act - especially the small-scale or “20 investors/$2 million in 12 months” rule and offers to sophisticated investors. It’s worth reviewing section 708 to understand which exemption you’ll rely on.

Sophisticated And Professional Investors

If you’re targeting larger cheques, you’ll often work with sophisticated or professional investors who meet asset or income thresholds (usually evidenced by an accountant’s certificate). You can read more about who qualifies in Sophisticated Investors and related definitions.

Company Approvals And Documents

Issuing notes requires the right company approvals and governance. Make sure your Company Constitution allows for convertible instruments and that director/shareholder approvals are documented properly.

Cap Table And Shareholder Arrangements

Notes convert into equity later, so plan ahead for dilution and control. If you have co-founders or existing investors, align on how conversions will affect decision-making. It’s common to review or update your Shareholders Agreement before you open a note round.

Consumer, Privacy And Employment Laws

Fundraising doesn’t replace your day-to-day compliance. As you scale with new capital, continue meeting your obligations under Australian Consumer Law, the Privacy Act (if you collect personal information), and workplace laws if you’re hiring.

Convertible Notes Vs SAFEs: Which Is Better?

There’s no one-size-fits-all - it depends on your stage, investor preferences and how fast you need to move.

• Convertible notes are debt instruments. They can accrue interest and have a maturity date, which gives investors downside protection but adds a repayment risk if there’s no conversion event.
• SAFEs are not debt, typically have no interest or maturity date, and can be simpler to negotiate. However, some investors prefer the protections of a note.

From a founder perspective, SAFEs can reduce pressure around maturity, while notes may be more attractive to investors seeking a defined timeline. Either way, keep your documents cohesive and consistent across your early-stage rounds.

Step-By-Step: How Do I Issue Convertible Notes?

Here’s a practical sequence to follow when running a notes round in Australia.

1) Map Your Funding Plan And Cap Table

Decide how much you’re raising, your target investor profile, and whether you’ll offer a cap, discount, or both. Build conversion scenarios so you understand dilution at different future valuations.

2) Prepare A Clear Term Sheet

Before drafting long-form documents, align on headline terms: cap, discount, qualifying round definition, interest, maturity, and key investor rights. A concise Term Sheet helps you move quickly and sets expectations early.

3) Confirm Your Legal Pathway

Identify which fundraising exemption you’ll rely on (often under section 708) and whether you’re approaching sophisticated investors. If needed, plan how you’ll collect investor certificates.

4) Draft The Convertible Note Document

Get the note instrument tailored to your company’s constitution, cap table and future plans. Keep definitions tight (what is a “Qualified Financing”?), and make sure MFN, pro rata, and consent rights align across investors. Many founders also prepare a short deck or offer pack in line with their capital raising strategy.

5) Approvals, Execution And Funds Flow

Record director approvals and any shareholder consents required under your constitution or shareholders agreement. Execute the notes, receive funds, and update your cap table and finance records. If your notes include any security, ensure proper registration steps are followed.

6) Ongoing Investor Relations

Provide information updates in line with your note terms. Keep investors briefed on runway, milestones, and timing for your next equity round - it builds trust and eases the conversion process later.

What Documents Will I Need?

You won’t need every document on this list, but most convertible note rounds include several of the following:

• Term Sheet: A short-form summary of the key deal terms to align parties before drafting full documents.
• Convertible Note Instrument: The core agreement (or deed) setting out conversion mechanics, cap/discount, interest, maturity, and investor protections.
• Board And Shareholder Resolutions: Approvals to issue notes and, later, to convert notes into shares.
• Updated Cap Table: A live model showing the impact of conversion at various future valuations.
• Company Constitution: Ensure it permits issuing convertible instruments; consider updates if needed through your Company Constitution or related documents.
• Shareholders Agreement: Review provisions on pre-emptive rights, new issues and decision-making; you may need amendments to your Shareholders Agreement.
• Investor Qualification Materials: For sophisticated/professional investors, accountant certificates and acknowledgements where required.
• SAFE Templates (if relevant): If you offer both instruments at pre-seed, keep your SAFE Note terms aligned with your notes to avoid inequities.

Common Pitfalls (And How To Avoid Them)

• Unclear conversion math: Ambiguous definitions around “pre-money,” “post-money,” or the cap mechanics can cause disputes. Lock down the price-per-share formula and include worked examples where helpful.
• Maturity crunch: A hard repayment obligation can create cash pressure if your round slips. Consider an auto-convert on maturity or investor election instead of mandatory repayment.
• Stacking inconsistent terms: If you issue notes on different terms, MFN clauses can ripple through. Keep a single, consistent template for a rolling raise.
• Forgetting the cap table: Run scenarios for different future valuations so you and your co-founders aren’t surprised by dilution later.
• Missing governance updates: Make sure director/shareholder approvals, constitutional authorities and filing requirements are handled before accepting funds.
• Relying on the wrong exemption: If you exceed the small-scale offering limits or approach retail investors incorrectly, you may breach fundraising rules. Align your investor outreach with your chosen exemption under section 708 and focus on sophisticated investors where possible.

Key Takeaways

• Convertible notes let you raise funds now and convert to equity later, typically using a valuation cap and/or discount at your next priced round.
• Pay close attention to conversion triggers, interest, maturity, MFN and investor protections so the instrument fits your runway and growth plans.
• Australian raises commonly rely on Corporations Act disclosure exemptions, especially offers to sophisticated investors under section 708.
• Make sure your Company Constitution and Shareholders Agreement support issuing and converting notes, and record approvals properly.
• A clear Term Sheet, cohesive note template and disciplined cap table modelling will keep your round clean and conversion smooth.
• Getting tailored legal help early can prevent costly errors and keep your capital raise moving quickly.

If you’d like a consultation about issuing a convertible note for your startup, you can reach us at 1800 730 617 or team@sprintlaw.com.au for a free, no-obligations chat.