What should the interest rate for a convertible note be?

Takeaway: Convertible notes are issued as a way for an investor to ultimately purchase equity of the company. They are not intended to function like debt and accrue lots of interest. In my opinion, interest rates on notes for non-distressed companies should be between the applicable federal minimum rate and 6%.

When a startup is looking to raise funds, one of the most common ways to do so is through a convertible note. A convertible note is a type of debt that can be converted into equity at a later date, usually when the company raises its next round of funding. The interest rate on a convertible note is an important consideration for both the company and the investors.

Typically, the interest rate on a convertible note for a startup ranges from the applicable federal minimum rate (AFR) to 6% per annum. The applicable federal minimum rate is published by the Internal Revenue Service monthly here. My opinion is that interest rates on convertible notes should be minimal because the purpose of a convertible note is to be an easy mechanism to purchase equity in a startup, not a loan where the investor intends to earn interest. In general, the interest rate should be set at a level that is fair to both the company and the investor.

As background, the interest rate on a convertible note is important because it determines the amount of interest that the investor will earn on their investment before the note is converted into equity. This interest is usually added to the principal amount of the note and is paid out when the note is converted.

Overall, the interest rate on a convertible note for a startup should be set at a level that is fair to both the company and the investor. It should take into account the level of risk involved. By carefully considering these factors, startups can set an interest rate that will attract investors and help them raise the funds they need to grow their business.