Equity
Convertible Notes and Your 409A: Why Debt That Converts Still Moves Your Strike Price
A convertible note is debt today, but your 409A prices it like equity. How the cap and discount move value away from common stock and reset your strike price.
By 409.AI Team - 2026-07-28
# Convertible Notes and Your 409A: Why Debt That Converts Still Moves Your Strike Price
You raised your first outside money on a convertible note. On the balance sheet it sits there as a liability, quiet and boring, accruing a little interest while you go build. It feels like the one piece of your cap table that has nothing to do with equity. Then your 409A provider asks for the note's terms, and a few weeks later your common stock is worth something different than you expected.
That surprise catches a lot of founders. A convertible note is a loan today, but the whole point of it is to stop being a loan. It's a promise to turn into stock, and your 409A appraiser has to price that promise. Here's how a note flows through the valuation and lands on the strike price your team pays to exercise their options.
A convertible note is a loan that wants to become stock
A convertible note is short-term debt. It has a principal amount, an interest rate (usually somewhere between 4% and 8%), and a maturity date. What makes it different from a normal loan is the conversion feature: instead of getting paid back in cash, the investor's principal plus accrued interest usually converts into equity at your next priced round, typically the same preferred stock the new lead investor buys.
That's the piece founders miss. The note is written as debt, but almost nobody expects it to be repaid in dollars. Everybody expects it to become shares.
This is the family the SAFE belongs to as well, and the two get lumped together constantly. They aren't the same instrument. A SAFE isn't debt: no interest, no maturity date, nothing to default on. A note is a real loan with a real clock on it. We covered the SAFE side of this in [how SAFEs affect your 409A valuation](https://www.409.ai/articles/how-safes-affect-your-409a-valuation); this piece is the convertible-note companion.
Which one you'll actually see depends on the stage. SAFEs have taken over pre-seed, running close to 90% of those deals because they're cheap and simple. Notes never went away, though. Convertible debt issuance ran to roughly $48 billion in 2024, and notes stay common in bridge rounds, angel rounds, and any deal where the investor wants the protections that come with being a creditor: a maturity date, interest, and a seat closer to the front of the line if things go sideways.
The two levers that decide what the note is worth: the cap and the discount
A convertible note almost always converts on better terms than the new money in the priced round. That reward comes through two levers, and the investor typically gets whichever one helps them more.
The discount is the simpler of the two. A 20% discount means the noteholder converts as if the new round's price were 20% lower than it actually is. Discounts usually run 10% to 20%, and 20% is close to a market standard.
The valuation cap sets a ceiling on the company valuation used to price the noteholder's conversion, no matter how high the priced round comes in. It's the early investor's reward for taking on the most risk. If your note has an $8M cap and you later raise at a $20M valuation, the noteholder still converts as though the company were worth $8M.
A worked example makes the interaction concrete. Say you raise $1M on a note with a 20% discount, an $8M cap, and 5% interest, and 18 months later you close a priced round at a $12.00M pre-money valuation with 6,000,000 fully diluted shares, so the new price is $2.00 per share.
- Interest first: $1,000,000 at 5% for 1.5 years adds about $75,000, so roughly $1,075,000 converts.
- Discount path: $2.00 minus 20% gives a $1.60 conversion price. That buys about 671,875 shares.
- Cap path: an $8M cap over 6,000,000 shares implies about $1.33 per share. That buys about 806,250 shares.
The noteholder takes the cap here because it's the lower price and the bigger stake. They convert at roughly $1.33 while the new investors pay $2.00. Exact cap mechanics vary with how the note defines the share count, so treat the numbers as illustrative, but the direction holds: the note buys in cheaper than the round it converts into.
Why your 409A cares about a note it may never repay
Now the accounting and the valuation start to disagree, and both are right in their own frame.
For financial reporting, your note is a liability. It's borrowed money you owe until it converts or is repaid, and that's how it lands on the balance sheet. If you're already thinking about how equity instruments hit your books, our [ASC 718 guide for startups](https://www.409.ai/articles/asc-718-stock-based-compensation-startup-guide) walks through the reporting side of stock comp.
Your 409A appraiser looks at the same note and sees something else. Because everyone expects it to convert rather than be repaid in cash, valuation firms generally model a convertible note as quasi-equity, assuming it turns into stock and takes its place in the ownership waterfall. The question the appraiser is really answering is how much of your company's value the noteholders will claim on conversion, because whatever they claim is value that isn't sitting behind your common shares.
That waterfall is the heart of a 409A. Total equity value goes in at the top, the senior claims get paid in order, and common stock gets what's left after everyone ahead of it is satisfied. Convertible noteholders, converting cheaply thanks to the cap and discount, slot into that stack ahead of common. If you want the full picture of how appraisers split company value into a common-stock price, we broke it down in [OPM vs. PWERM](https://www.409.ai/articles/409a-allocation-methods-opm-pwerm-backsolve).
So does a note push your 409A up or down?
The honest answer is that it depends, and anyone who gives you a one-word answer is guessing.
Two forces pull in opposite directions. The cash you raised makes the company genuinely more valuable, which pushes the whole enterprise value up. But a note with a low cap and a steep discount hands a large, cheaply priced slice of that value to the noteholders, which pulls value away from common. When the second effect dominates, a note can actually hold your common stock FMV down, because common shareholders are absorbing more of the downside while the noteholders lock in the upside.
That's not a bug. A 409A is supposed to reflect that common stock sits at the bottom of the stack. It's the same reason your 409A comes in well under your headline round number, which we unpack in [why your 409A is lower than your post-money valuation](https://www.409.ai/articles/why-is-your-409a-valuation-lower-than-post-money-valuation). A note deepens that gap rather than closing it.
When a note triggers a new 409A
Timing is where founders get tripped up, because the note has two moments that can matter.
The IRS safe harbor treats a 409A as reasonable for up to 12 months, as long as no material event happens in the meantime. A material event is anything that would meaningfully change your value, and a financing is the classic example. A priced round that converts your notes is unambiguously a material event, and you'll need a fresh 409A after it closes to set strike prices going forward. That's a core part of what makes VC money reset your obligations, which we cover in [409A valuation for venture capital funding](https://www.409.ai/articles/409a-valuation-for-venture-capital-funding).
The note round itself is the grayer case. A small angel note usually won't move your FMV enough to force a revaluation on its own. A large note round, priced with an aggressive cap, can be material enough that a careful appraiser wants to reflect it. If you're granting options around the time you close a note, that timing question is worth raising directly with your provider rather than assuming your existing report still holds. Our [walk-through of the 409A process](https://www.409.ai/articles/inside-the-409a-valuation-process) covers where these material-event judgment calls fit in.
What it means for your team's strike price
Here's why any of this reaches your employees. The output of a 409A is the fair market value of your common stock, and that FMV becomes the exercise price on every option you grant until the next valuation. Set the strike at or above that FMV and your options clear the 409A safe harbor. Set it below, and your employees can face immediate taxes and a 20% additional tax under Section 409A on the shortfall.
So the chain runs straight through: the terms of a note you signed help set your common FMV, that FMV sets the strike price, and the strike price decides what your engineers pay to turn options into shares and how those shares get taxed later. If you want the downstream tax picture, [ISO vs. NSO stock options](https://www.409.ai/articles/iso-vs-nso-how-stock-options-are-taxed) lays out how each option type is taxed once that strike is locked in.
The takeaway
A convertible note isn't a side deal you can wall off from your equity. It's a claim on your company's value that your 409A has to price today, even though it won't become stock until later. Before you sign one, get clear on two things: how the cap and discount will slot noteholders ahead of your common stock in the waterfall, and whether the round is large enough that you'll owe a fresh 409A before your next batch of option grants. Ask your valuation provider those questions while the term sheet is still a draft, not after your team's strike prices are already set. The note is cheap to sign and expensive to misunderstand.