Convertible notes are like the Swiss Army knives of early-stage startup financing—versatile, efficient, and widely used. Founders love them for their speed and simplicity. Investors appreciate the upside potential they offer without the complexity of equity negotiations upfront. But when it’s finally time to convert those notes into equity—or get repaid—what started as a friendly funding tool can evolve into a full-blown litigation battlefield.
As we’ve seen time and again in our own practice at Jabaly Law, disputes over convertible notes are rarely about the initial deal. They emerge when the business matures and value becomes real. That’s when assumptions get tested, contracts get scrutinized, and positions get entrenched. In this blog, we’ll walk through the most common litigation triggers in convertible note agreements, unpacking why things go sideways and how parties tend to respond—legally.
And if you want a big-picture view of how high-stakes startup funding can lead to unexpected financial and legal chaos, this Forbes breakdown is a good place to start.
The Basics: What’s a Convertible Note, Really?
Before diving into disputes, let’s get clear on what a convertible note is. In short, it’s a hybrid financial instrument—part loan, part equity. Startups use it to raise money from investors with the promise that the amount invested (plus interest) will convert into equity at a future financing event, typically when a Series A round occurs.
These agreements usually include terms like:
- Valuation cap (the maximum company valuation at which the note converts)
- Discount rate (a percentage discount to the future investors’ price)
- Maturity date (when the note must be repaid or converted)
- Triggering events (what causes the note to convert)
Now, let’s look at the friction points.
Triggering Events: The Root of Most Disputes
Triggering events are pivotal moments outlined in the agreement that determine when the note either converts into equity or becomes due for repayment. These are supposed to offer clarity, but often they do the opposite.
One of the most litigated elements in our experience is whether a qualifying financing event has occurred. If a startup raises funds but doesn’t meet the threshold defined in the note (say, $1 million minimum), investors might claim conversion rights anyway—arguing that the intent was met. Startups, meanwhile, may argue it was just a bridge round, not the “real” one.
If the agreement doesn’t clearly define the thresholds or makes assumptions about follow-on investments, courts get involved. These cases often require nuanced interpretation, particularly in jurisdictions like Virginia and Washington, DC, where business litigation statutes differ in how contractual ambiguity is handled. For that reason, involving a litigation attorney or a business attorney with deep familiarity in financing litigation becomes essential.
Valuation Disagreements: Discount or Cap?
Investors typically get rewarded for early risk through valuation caps and discounts, but things can go south if the parties interpret those mechanics differently. Here’s how:
Let’s say an investor has a note with a valuation cap of $5 million, but the company raises its Series A at a $10 million valuation. The investor expects to convert their note at the capped valuation (i.e., better terms), while the startup founders argue that the conversion math should include the latest SAFE notes or new preference shares, diluting the investor more than expected.
We’ve seen scenarios where investors argue that founders manipulated post-money valuations or restructured equity classes in a way that unfairly disadvantages them. This becomes especially heated when companies grow rapidly and are suddenly worth far more than anticipated. Whether you’re a real estate attorney dealing with capital structures in property startups or a business litigation attorney, the valuation terms are often the battleground.
Maturity Dates and Repayment Rights: Loans or Traps?
If a startup hasn’t had a conversion-triggering event by the note’s maturity date, the note becomes due—like any loan. But here’s the twist: most startups at this stage still don’t have the cash to repay it. Investors may choose to extend the note, convert at a fixed price, or demand repayment.
Where litigation crops up is when one party assumes extension is automatic (or even implied by conduct), while the other insists on their legal right to repayment. Some founders may even argue that forcing repayment is being used as leverage to extract better terms or equity.
In those cases, the enforceability of the repayment clause is tested. Whether the courts treat the note as a true debt instrument or a de facto equity deal often depends on the language and local case law precedent. This is where business law consultations or legal counsel services for businesses can provide critical clarity during drafting stages—before these clauses become courtroom exhibits.
Ambiguous or Conflicting Terms
One of the lesser-talked-about but extremely common litigation triggers is simply bad drafting. We’ve encountered convertible note agreements that are riddled with inconsistencies—especially if cobbled together using templates or rushed legal advice.
Examples include:
- Different definitions of “Qualified Financing” in different sections
- Conflicting language around what happens at maturity
- No clarity on what happens in an acquisition or merger
- Lack of governing law or jurisdiction clauses
These issues are exacerbated when parties are in different states—say, a DC-based investor and a Virginia-based startup. Which laws govern? Which courts have jurisdiction? For clients needing litigation attorneys, we’ve helped untangle these messes before they spiral into expensive court battles.
Exit Events: Acquisition, Liquidation, and the “What Now?” Problem
Let’s talk about one of the most emotionally charged litigation triggers: exit events.
If a company is acquired before the note converts, some agreements allow for automatic conversion, others permit repayment (sometimes with a multiplier), and some are completely silent on the matter.
That silence can turn into a major issue. Investors who thought they’d get shares in the acquiring company suddenly find themselves offered pennies. Or worse, nothing at all if common shareholders are wiped out during the liquidation preference payout.
The outcome of these disputes often hinges on whether the note is treated more like equity or debt—especially in tight acquisition structures. This is where a trial attorney or a professional business attorney becomes vital. Knowing how courts interpret conversion clauses during acquisitions is more than a technical reading—it’s a strategic positioning play.
Lack of Board Disclosures and Investor Updates
Finally, not all litigation arises from terms in the contract. Sometimes, it’s about behavior.
Investors who’ve put money in under convertible notes often expect to be kept in the loop. When a startup fails to notify them of new rounds, down rounds, or acquisition negotiations, disputes over fiduciary duties and good faith quickly follow.
Although convertible noteholders are often not voting shareholders (until conversion), their expectation of transparency—especially when material events affect their economic interest—can lead to claims of bad faith or even fraud.
In Virginia, where business law tends to respect clear contract language but allows room for equity-based arguments, we’ve successfully argued both sides of this issue depending on the facts. Whether it’s a startup attorney or a litigation attorney, experience matters in assessing the fine line between aggressive corporate strategy and potential liability.
Why Early Legal Structuring Can Prevent Litigation
From valuation mechanics to ambiguous clauses and triggering events, convertible notes have evolved into complex legal instruments hiding behind a “simple” reputation. Drafting these agreements with precision—and anticipating disputes from the start—isn’t just smart. It’s essential.
And as our clients navigate startup funding, acquisitions, or corporate restructuring in Fairfax, Alexandria, and DC already know, the best protection is proactive legal counsel. You don’t need to wait for a triggering event to start thinking about litigation risk.
Ready for Experienced Legal Counsel?
At Jabaly Law, our experienced business lawyer in Alexandria, VA, has been deeply involved in high-stakes corporate litigation and startup transactions. That experience informs how we approach every convertible note dispute—with clarity, strategy, and the intuition that only comes from having seen it all. Whether you’re facing valuation battles, ambiguous triggering events, or repayment showdowns, we offer legal counsel services for businesses in Fairfax, VA, Arlington, VA, and more.
Call now to schedule a confidential consultation or explore our services to see how we can support your funding agreements before they turn into lawsuits. Learn more about our approach and background at Jabaly Law.
