What should the interest rate for a convertible note be?
Takeaway: The interest rate on a convertible note is not meant to be a major economic term, but a placeholder; it is typically set at a low, standard market rate of 4% to 8% per year.
Because a convertible note is a debt instrument, one of its fundamental legal features is that it must accrue interest. This interest, along with the principal amount of the loan, will eventually convert into equity at your next priced financing round. For founders who are not accustomed to debt financing, the concept of an interest rate can be a point of confusion and unnecessary negotiation.
The key thing to understand is that for a standard convertible note in a seed-stage financing, the interest rate is not meant to be a significant source of return for the investor. The investor's real return comes from the valuation cap and the discount, which give them a more favorable price on their equity. The interest rate is largely a market convention and a legal formality.
The Market Standard
While the interest rate is technically negotiable, the market has settled on a very standard and consistent range. The vast majority of seed-stage convertible notes have a simple, non-compounding interest rate of between 4% and 8% per year.
A rate below 4% is uncommon and may be seen as too founder-favorable by investors.
A rate above 8% is also uncommon and would be considered aggressive and investor-favorable.
For most deals, a rate of 5% or 6% is a perfectly standard, non-controversial starting point that will be accepted by nearly all investors without any negotiation.
Why Does Interest Exist at All?
If the interest rate is not a major economic term, why have it?
It's a Legal Formality: Because a convertible note is legally structured as a loan, it must have an interest rate to be a valid debt instrument.
A Minor "Kicker" for Investors: The accrued interest provides a small additional "kicker" for the investor upon conversion. When the note converts, the investor gets to convert not just their original principal, but the principal plus the interest they have earned, giving them a slightly larger number of shares.
The Negotiation Tactic
Founders should not spend significant time or energy negotiating the interest rate on a convertible note. It is a minor economic term, and trying to negotiate it down from 6% to 5%, for example, will save you a negligible amount of dilution while signaling to investors that you are focusing on the wrong things.
A much more important use of your negotiating capital is to focus on the single term that truly matters: the valuation cap. The valuation cap will have a thousand times more impact on your dilution and the ultimate economics of the deal than a minor change in the interest rate. Accept the standard market rate for interest and focus your energy on negotiating the most important term on the table.
Disclaimer: This post is for general informational purposes only and does not constitute legal, tax, or financial advice. Reading or relying on this content does not create an attorney–client relationship. Every startup’s situation is unique, and you should consult qualified legal or tax professionals before making decisions that may affect your business.