A convertible note is debt that converts into equity at a future round, typically at the lower of a discounted price or a capped price, with interest added to the amount converting.
12 min read · Level 3
I think the most useful way to see a convertible note is as an option to buy shares at a protected price, with a loan wrapped around it for legal reasons. The loan part rarely gets repaid in practice, but it quietly shapes negotiations at maturity, which is why reading those clauses matters as much as the cap.
A convertible note starts as a loan. It accrues interest and has a maturity date. At a qualifying priced round it converts into shares, usually with two features that benefit the holder:
Discount a percentage off the new investors' price Cap a maximum valuation used to set the conversion price
The holder gets whichever produces the lower price per share.
A note of 250,000 with 6% simple interest converts after one year, so the amount converting is 265,000. The note has a 20% discount and a 4,000,000 cap. The Series A is priced at a 10,000,000 pre-money valuation, with 10,000,000 shares before the round, so the Series A price is 1.00.
Discount price 1.00 x (1 - 20%) = 0.80 Cap price 4,000,000 / 10,000,000 shares = 0.40
The cap gives the lower price, so the holder converts at 0.40:
At cap price 265,000 / 0.40 = 662,500 shares At discount price 265,000 / 0.80 = 331,250 shares
The cap doubles the shares compared with the discount.
Because it is debt, a note that reaches maturity without converting can in principle be repaid or renegotiated. In practice, early-stage companies often cannot repay, and maturity leads to extension or conversion on new terms.
Because the cap and discount determine the effective price paid, and the difference can be large. Understanding both lets an investor see the real deal and a founder see the real dilution.
The debt features also matter in a bad outcome: a noteholder may rank ahead of shareholders if the company fails before conversion.
Educational, not personalised financial advice. Nothing in the Investor Academy is a recommendation to buy, sell or hold anything — what is right for you depends on your own circumstances and the rules where you live.
When the round is priced below the cap. Same note, but Series A is at a 3,000,000 pre-money with 10,000,000 shares, so the Series A price is 0.30.
Discount price 0.30 x 0.80 = 0.24 Cap price 4,000,000 / 10,000,000 = 0.40
Now the discount gives the lower price: 265,000 / 0.24 = about 1,104,167 shares. The cap no longer matters, because the round came in below it. A note's protection works on both sides: the cap helps when valuations are high, the discount when they are low.
Looking only at the cap, or only at the discount. The holder receives whichever produces the lower conversion price, which depends on the round's valuation.
Compute the amount that will convert, including interest to the conversion date.
Calculate the discounted price and the capped price for the expected round.
Divide the converting amount by the lower price.
Read what happens at maturity if no round has occurred, including repayment, extension or automatic conversion.
When investing through a convertible note or evaluating a company with notes outstanding.
Do not assume all notes calculate the cap price the same way. Definitions of the share count used for the cap vary and must be read in the documents.
Startup lawyers and investors commonly describe convertible notes reaching their maturity dates before the company raised a qualifying round, leading to extensions, conversions at the cap or renegotiated terms, since few early-stage companies had cash to repay the loans.
Treat a note's maturity date as a negotiation point that may arrive before a round, and read what the documents allow.
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