A convertible debt example is easiest to follow with a single deal and the arithmetic laid out step by step. Here is the short version: a $100,000 note at 5% simple interest, with a $5 million valuation cap and a 20% discount, converts one year later into 210,000 shares of Series A preferred stock when the company raises at a $10 million valuation and a $1.00 share price. The investor’s effective price works out to $0.50 per share, half of what the new Series A money paid. The sections below walk through how each number is produced and why the cap wins over the discount in this scenario.
The Variables That Drive the Math
Before the numbers mean anything, five terms from the convertible promissory note have to be pinned down. Each one shows up in the calculation.
Principal. The cash the investor wires at closing. Seed-stage checks run from tens of thousands to a few million dollars.
Interest rate. Convertible notes carry simple annual interest, commonly 4% to 8%. The interest accrues on paper rather than being paid in cash, so the amount that eventually converts grows with time.
Maturity date. If no qualifying funding round closes by this date, the outstanding principal and accrued interest become due and payable at the noteholders’ request. Most notes set maturity 18 to 24 months from closing.1University of Pennsylvania Law School. Convertible Promissory Note
Valuation cap. A ceiling on the company valuation used to price the investor’s shares. If the next round values the company above the cap, the investor’s conversion price is calculated as though the company were only worth the capped amount. Lower cap, more shares.
Discount rate. A percentage reduction off whatever price new investors pay in the next round. A 20% discount on a $1.00 share means the noteholder pays $0.80.1University of Pennsylvania Law School. Convertible Promissory Note
Qualified financing. The trigger that forces automatic conversion. The note defines a minimum dollar amount the company must raise in a priced round for it to count. Raise less, and the note stays as debt.
Most notes carry both a cap and a discount, and the investor converts at whichever method produces the lower price per share. A lower price means more shares for the same dollar amount of debt, so the investor always ends up on the better of the two calculations.
The Scenario
Here are the terms of the sample deal:
- Principal: $100,000
- Interest rate: 5% simple annual interest
- Valuation cap: $5 million
- Discount rate: 20%
- Time to conversion: exactly one year
One year after closing, the startup raises a Series A that values the company at $10 million, with new investors paying $1.00 per share of preferred stock. The round clears the qualified financing threshold written into the note, so conversion happens automatically. The question is how many shares the original noteholder receives.
Running the Conversion Math
Start with the amount of debt owed. The $100,000 principal plus one year of simple interest at 5% comes to $105,000. The full $105,000 converts, not just the original loan amount.
Discount Price
The 20% discount applies to the Series A share price of $1.00. That produces a conversion price of $0.80 per share. At $0.80, $105,000 buys 131,250 shares.
Valuation Cap Price
The cap price is the $5 million cap divided by the company’s fully diluted share count immediately before the round. Since the Series A values the company at $10 million at $1.00 per share, the pre-round share count is 10 million. Dividing $5 million by 10 million gives a conversion price of $0.50 per share. At $0.50, $105,000 buys 210,000 shares.
Picking the Better Price
The investor converts at whichever price produces more shares. The $0.50 cap price beats the $0.80 discount price, so the investor receives 210,000 shares. Series A investors paid $1.00 for the same class of stock. The early investor’s effective price is half of what later money paid, which is the reward the cap was designed to provide.
When the Discount Would Have Won Instead
The gap between the two methods widens as the company’s valuation climbs above the cap. It narrows, and eventually reverses, when growth is modest.
Rerun the example with a Series A valuation of $6 million rather than $10 million, still at $1.00 per share. The cap price now works out to roughly $0.83 per share ($5 million divided by 6 million pre-round shares). The discount price is still $0.80. At those numbers, the discount produces more shares, so the discount method controls the conversion. The cap only becomes the dominant term when the next round’s valuation significantly exceeds what the founder and investor originally anticipated.
What Conversion Looks Like on the Cap Table
Once the share count is set, the company cancels the original promissory note to reflect that the debt has been satisfied.2U.S. Securities and Exchange Commission. Form of Convertible Note Cancellation Agreement The investor signs either a stock purchase agreement or a joinder that brings them into the Series A deal on the same terms as the other equity holders, binding them to the same rights, preferences, and restrictions the new investors negotiated.
The capitalization table is updated to show the new shares and the investor’s ownership percentage. Ownership may be evidenced by a stock certificate or, more commonly, by an electronic entry on a digital equity management platform. The paperwork typically wraps within a few days of the Series A closing.
The Dilution Side of the Same Math
The 210,000-share figure looks different from the founder’s seat. Series A investors paying $1.00 per share would need to spend $210,000 to pick up the same stake the noteholder got for a debt that started at $100,000. The early investor’s discount comes directly out of the founder’s ownership percentage.
The effect compounds when a company has issued multiple convertible notes over time, especially if each carries its own valuation cap. Founders sometimes discover at the Series A closing that the combined conversion of all outstanding notes consumes more of the cap table than they expected. Before signing any note, model the conversion at several different Series A valuations. Running the arithmetic above at an optimistic, middle, and pessimistic valuation takes a few minutes and shows how ownership moves in each case.
What If the Maturity Date Arrives First
The example assumes a qualified financing closes before maturity. When it does not, the outstanding principal plus accrued interest technically becomes due. Most early-stage startups do not have that cash available, and demanding repayment could push the company toward insolvency. Three outcomes are common in practice.
- Extension. The parties agree to push maturity out by 6 to 12 months, sometimes with a lower valuation cap or higher interest rate as compensation to the investor.
- Conversion at the cap. Some notes let the investor convert into equity at the valuation cap even without a priced round, which gives the investor shares and clears the debt from the books.
- Default. If the parties cannot agree and the company cannot pay, the note goes into default. Default provisions often raise the interest rate sharply; one SEC-filed note escalated the rate to 18% on default.3U.S. Securities and Exchange Commission. Q2 Power Technologies Inc – Form of Convertible Promissory Note
Extension is by far the most common resolution. Neither side benefits from forcing a cash-strapped company into a corner, and the investor’s best shot at a return is keeping the company alive long enough to raise a priced round. Even so, the maturity date is not a formality; a sophisticated investor can use it as leverage to renegotiate the cap, the discount, or the interest rate in their favor before agreeing to extend.