Hong Kong startups often need capital long before their numbers justify a valuation, and the convertible note is the instrument built for exactly that gap. It is a loan that converts into shares at a later priced round, which is why founders ask how convertible notes work before signing one.
In this blog, we discuss what a convertible note is, the key terms to negotiate, how the conversion maths works, and the Hong Kong legal, regulatory and tax points founders should know. We also compare convertible notes with SAFEs and priced equity, and set out the practical steps to take before signing.
What Is a Convertible Note and How Does It Work?
A convertible note is short-term debt that the startup repays in shares, not cash, once a trigger event such as a priced funding round takes place.
The instrument has two stages. In the first, it behaves like a loan: the company receives money, the note accrues interest, and no valuation is negotiated. In the second, the outstanding balance converts into shares under a set formula, and the investor becomes a shareholder.
For Hong Kong startups, this solves a familiar early-stage problem. Pre-revenue companies rarely have the traction to justify a firm valuation, yet founders still need capital to reach the next milestone. A note postpones the pricing conversation until a lead investor sets one.
Notes are typically issued by private limited companies incorporated through the Companies Registry. They suit pre-seed and seed rounds, bridge financings between rounds, and overseas investors who prefer short documents to a full share subscription.
1. Debt first, equity second
The note starts as a loan and becomes equity only when a conversion trigger occurs. Until then, the investor is a creditor, not a shareholder.
2. No valuation today
Both sides defer the valuation question until a later round. The discount and the cap replace the price negotiation that slows priced rounds.
3. Faster documentation
A note runs to fewer pages than a share subscription with a shareholders' agreement. Lower legal spend and quicker signatures are the point.
4. Built-in reward for early risk
The discount gives investors a cheaper conversion price than later-round investors pay. The cap protects them if the company's valuation rises sharply.
Which Key Terms Should Founders Review Before Signing?
The core terms that drive the economics are the discount, the valuation cap, the interest rate, the maturity date and the conversion trigger. Founders weighing these terms should also understand the 3 things needed in a founders agreement in Hong Kong.
Hong Kong rounds are individually negotiated, so ranges vary. Treat the terms below as a checklist to review, not a template to accept unchanged. The table that follows sets out typical practice.
1. Discount rate
The discount lets the investor convert at a price below the round price, commonly 10% to 20% in early rounds. It rewards the investor for arriving before the valuation is proven.
2. Valuation cap
The cap fixes the highest valuation that can be used in the conversion formula. It protects the investor if the next round prices the company far above expectations.
3. Interest rate
Most notes accrue simple interest, often in the 2% to 8% per annum range. Interest usually rolls into the conversion amount rather than being paid in cash.
4. Maturity date
The maturity date, often 12 to 24 months, sets the deadline for a trigger event. What happens at maturity must be written into the note.
5. Conversion trigger
The trigger is usually a qualified financing above an agreed minimum. Maturity, a change of control or a listing can also convert the note, depending on the drafting.
6. Ancillary rights
Information rights and participation rights on conversion are common. Keeping these light preserves the speed that makes notes attractive.
Convertible Note Terms at a Glance
| Term | What it does | Common practice in Hong Kong rounds |
|---|---|---|
| Discount rate | Lets investors convert below the round price | Around 10% to 20% |
| Valuation cap | Caps the valuation used to calculate the conversion price | Negotiated case by case |
| Interest rate | Accrues onto the note until conversion or repayment | Simple interest, often 2% to 8% per annum |
| Maturity date | Sets the deadline for the conversion trigger | 12 to 24 months from issue |
| Conversion trigger | Defines the event that converts the note into shares | Qualified financing above an agreed minimum |
| Repayment option | Governs the outcome if no trigger occurs | Repay with interest, extend or convert at the cap |
Conversion applies the lower of the discounted round price and the cap-derived price to the outstanding note balance.
When a trigger occurs, the shares issued equal the principal plus accrued interest, divided by the conversion price. The conversion price is the lower of the round price less the discount, and the price implied by the cap.
The cap-derived price equals the round price multiplied by the cap and divided by the round's pre-money valuation. If the cap is lower than the round valuation, the investor converts at the cheaper cap price; if not, the discount applies instead.
The worked example below shows the arithmetic on a HK$1,000,000 note with a 20% discount and a HK$20,000,000 cap. The figures are illustrative, but the mechanics follow standard drafting.
After conversion, the company allots the shares and files the allotment with the Companies Registry. The register of members is updated, and the register of significant controllers may need review if thresholds change.
If maturity arrives with no round, the note document governs the outcome. Parties typically extend the date, repay with interest, or convert at the cap; negotiating early avoids a forced choice.
Convertible Note Conversion Worked Example
| Item | Value |
|---|---|
| Note principal | HK$1,000,000 |
| Interest rate | 5% per annum, simple |
| Accrued interest after 12 months | HK$50,000 |
| Conversion amount | HK$1,050,000 |
| Round price per share | HK$4.00 |
| Price with 20% discount | HK$3.20 |
| Cap-derived price (HK$20m cap, HK$40m pre-money) | HK$2.00 |
| Conversion price applied (lower of the two) | HK$2.00 |
| Shares issued to the investor | 525,000 shares |
How Do Convertible Notes Compare With SAFEs and Priced Equity?
Notes sit between a SAFE and a priced round: debt today, equity economics tomorrow, and no valuation negotiation in between.
To see how convertible notes work in practice, set them beside the alternatives.
A simple agreement for future equity (SAFE) is a contract that promises shares at a later priced round. It carries no interest and no maturity date, so the investor never becomes a creditor.
A priced equity round issues shares immediately at an agreed valuation. It gives investors full shareholder protections, but the documentation and diligence take longer and cost more.
In Hong Kong, notes remain popular because the debt framework is familiar, interest may be deductible, and the maturity date creates discipline. SAFEs suit founders who want maximum speed and accept that there is no repayment fallback.
The comparison table below summarises the three structures.
Convertible Notes Versus SAFEs and Priced Equity
| Feature | Convertible note | SAFE | Priced equity round |
|---|---|---|---|
| Instrument type | Debt that converts into shares | Contract for future shares | Shares issued immediately |
| Valuation needed now | No | No | Yes |
| Interest accrues | Yes | No | No |
| Maturity date | Yes | No | Not applicable |
| Investor protection | Discount and cap | Discount and cap | Negotiated share price |
| Typical use | Pre-seed, seed and bridge rounds | Early rounds prioritising speed | Series A and later rounds |
What Legal and Regulatory Points Apply in Hong Kong?
The main watchpoints are securities-offering restrictions under the Securities and Futures Ordinance, board approvals, Companies Registry filings and stamp duty on later share transfers.
A convertible note may be a debenture or other security. The prospectus regime and the Securities and Futures Ordinance (Cap. 571), administered by the Securities and Futures Commission (SFC), can apply to the offer and its marketing.
For shares or debentures, prospectus safe harbours can include offers to no more than 50 persons, offers with a minimum principal amount of HK$500,000, small offers up to HK$5 million and offers solely to professional investors. Each route has technical conditions, including prescribed warnings where applicable. Founders should have Hong Kong legal counsel confirm the exemption and review the note and investor communications before circulation, because a breach can carry civil and criminal consequences.
Under the Companies Ordinance (Cap. 622), directors generally need prior company approval to allot shares or grant conversion rights; any contractual pre-emption rights in the articles or shareholders’ agreement should also be checked and waived or disapplied where necessary. Directors must also observe their duties when approving the issue.
Issuing a note does not pause standard corporate compliance requirements. The annual return is still due within 42 days after the anniversary of incorporation, and statutory registers must stay current.
No stamp duty arises on the issue of new shares. A later transfer of those shares attracts Hong Kong stamp duty at prevailing rates.
What Are the Tax Consequences for Startups and Investors?
Interest is the main tax lever: it can be deductible for the company, while conversion itself is usually not a taxable event for investors holding shares as capital.
For the company, accrued interest is expensed as it builds up. Interest deductibility is not automatic: the borrowed funds must be applied to produce assessable profits, and the claim must satisfy a qualifying condition under the Inland Revenue Ordinance (IRO). The use of funds, lender and financing terms should be documented at the outset.
The IRO imposes restrictions beyond the funds-use test. Depending on the arrangement, deductions can be denied or limited where a loan is secured by deposits that generate exempt interest, or where interest is paid to an associate or diverted to a related person that is not subject to sufficient tax. Startups should obtain tax advice before treating note interest as deductible.
For years of assessment from 2020/21 to 2026/27, all supplementary forms must be submitted electronically with the profits tax return through the IRD's portals. The two-tiered profits tax regime also taxes the first HK$2 million of qualifying assessable profits at a reduced rate, subject to connected-entity conditions.
For investors, Hong Kong has no capital gains tax, so converting a note into shares is usually not a taxable event where the shares are held as capital. Investors who trade securities as a business may still be taxable on their profits.
Individuals who receive cash interest rather than conversion can use personal income tax services in Hong Kong to review their filing position.
Which Practical Steps Should a Startup Take Before Issuing a Note?
Preparation beats paperwork: tidy the cap table, confirm the exemption route and document approvals before accepting the money.
In our experience, founders who map these five steps before signing close rounds faster and face fewer disputes at conversion.
Step 1: Confirm the vehicle
Startups that have not yet incorporated can begin with a free Hong Kong company name check, then use our Hong Kong company incorporation services to form a private limited company. Investors expect a Companies Registry-incorporated entity with clean records.
Step 2: Clean the cap table
Verify the share structure, any option pool and earlier notes that stack caps. Overlapping notes can surprise founders at conversion.
Step 3: Check the offering route
Count the investors, confirm professional-investor status where relevant and document the exemption relied on. Do this before circulating documents.
Step 4: Document approvals
Record board minutes for the allotment, disapply pre-emption in the articles where needed and update the statutory registers.
Step 5: Track conversion events
Diarise the maturity date, accrue interest monthly and prepare the Companies Registry filings that follow conversion.
Conclusion
A convertible note lets a Hong Kong startup raise capital without pricing its equity today, which is why founders ask how convertible notes work for their next round. The instrument is simple at heart, but the discount, cap, interest and maturity terms decide the dilution that follows.
Founders who prepare the cap table, confirm the exemption route and document approvals close faster and convert with fewer surprises. Getting the securities and tax position right at the outset is what keeps the round defensible.
As a Corporate Services Provider, 3E Accounting Hong Kong supports startups from incorporation through every funding round, with company secretarial, taxation and advisory services. Speak to our team before your next raise so the structure is right from day one.
Raise Your Next Round With Confidence
From incorporation to post-conversion filings, our team keeps your funding round compliant from start to finish.
Frequently Asked Questions
They are legally debt until conversion, which is why they carry interest and a maturity date. After conversion, the investor holds ordinary shares like any other shareholder.
The note document governs. Parties typically extend the maturity date, repay with accrued interest, or convert at the cap; the fallback must be agreed before signing.
It can be, but not automatically. The borrowed funds must be used to produce assessable profits, the interest must meet a qualifying condition under the Inland Revenue Ordinance, and anti-avoidance restrictions can apply to related-party or deposit-secured arrangements.
Generally no. Before conversion, their rights come from the note document, such as information rights, rather than from company law as shareholders.
Yes, subject to securities exemptions and investor-status checks. Once the notes convert, the share allotment is filed with the Companies Registry as usual.
Abigail Yu
Director
Abigail Yu oversees executive leadership at 3E Accounting Group, leading operations, IT solutions, public relations, and digital marketing to drive business success. She holds an honors degree in Communication and New Media from the National University of Singapore and is highly skilled in crisis management, financial communication, and corporate communications.
