What is a convertible note?

A convertible note is a type of investment that initially operates as a loan but is designed to convert into equity, typically in a future financing round. This mechanism is particularly popular in early-stage startups where investors are provided with the potential to convert their debt into ownership stakes in the company. The appeal of a convertible note lies in its simplicity and the ability for investors to defer the valuation of the company until a later funding round, thereby reducing some of the risks involved in investing at an early stage.

The conversion usually occurs at a predetermined discount to the price per share during the next equity round, or may involve a valuation cap, which limits the company's valuation for converting the note. This allows investors the opportunity to benefit from their early investment once the company has established more value.

The other options do not accurately represent the nature of a convertible note. A loan that is repayable in cash only does not align with the conversion aspect of a convertible note, while a security without equity rights fails to capture the key feature that allows investors to eventually acquire equity in the company. Lastly, a type of funding grant does not describe the financial instrument nature of a convertible note, as grants typically do not require repayment or conversion.