The interest converts too, the cap and the discount never both apply, and whether the Series A pre-money counts the note shares decides who pays for it.
A convertible note converts its principal plus accrued interest into shares at the lower of two prices: the valuation cap divided by the pre-round share count, and the round price less the discount. An illustrative 1,000,000 note at 6 per cent simple interest, with an 8,000,000 cap and a 20 per cent discount, converts after 18 months into a Series A priced at 2.00: 1,090,000 at 0.80 a share gives 1,362,500 shares, worth 2,725,000 at the round price, 2.73 times the principal.
Worked in full in The Venture Capital Associate by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The mechanics are close to a post-money SAFE, with three differences: the cap here is a pre-money cap, so the note's percentage is not fixed in advance, and two more: the note is debt, so it accrues interest that converts with it and adds to the share count, and it has a maturity date. And one term sheet question, whether the Series A pre-money counts the note shares, decides who bears the cost.
| Input | Value |
|---|---|
| Note principal | 1,000,000 |
| Interest, simple, per year | 6.0% |
| Months from issue to conversion | 18 |
| Valuation cap (pre-money) | 8,000,000 |
| Discount to the round price | 20.0% |
| Fully diluted shares before the round | 10,000,000 |
| Series A pre-money | 20,000,000 |
| Series A new money | 5,000,000 |
Converting amount = principal × (1 + rate × months ÷ 12)
Cap price = cap ÷ pre-round shares; discount price = round price × (1 − discount)
Shares = converting amount ÷ MIN(cap price, discount price)
In Excel, with principal in B1, rate B2, months B3, cap B4, discount B5, pre-round shares B6 and round price B7: =B1*(1+B2*B3/12)/MIN(B4/B6,B7*(1-B5)).
Step 1, the converting amount. Eighteen months at 6 per cent simple is 90,000 of interest, so 1,090,000 converts. Notes rarely pay interest in cash; it rides along into the round.
Step 2, the round price. 20,000,000 of pre-money over 10,000,000 shares is 2.00 a share.
Step 3, the two candidate prices. The cap gives 8,000,000 ÷ 10,000,000 = 0.80. The discount gives 2.00 × 0.80 = 1.60. The note takes the lower, 0.80: the cap binds, and the discount is irrelevant at this valuation.
Step 4, the shares. 1,090,000 ÷ 0.80 = 1,362,500 shares, worth 2,725,000 at the Series A price. Without the interest the note would receive 1,250,000 shares; the 18 months of interest is worth 112,500 shares, or 225,000 at the round price.
Here the term sheet matters more than the note. If the Series A pre-money of 20,000,000 is computed on the 10,000,000 existing shares only, the price stays at 2.00 and the note's shares are issued on top. If the investor's pre-money is defined to include the shares the note converts into, as many institutional term sheets require, the price is 20,000,000 ÷ (10,000,000 + 1,362,500) = 1.76.
| Holder | Pre-money excludes note shares | Pre-money includes note shares |
|---|---|---|
| Series A price per share | 2.00 | 1.76 |
| Existing holders | 72.14% | 70.41% |
| Noteholder (1,362,500 shares) | 9.83% | 9.59% |
| Series A investor | 18.03% | 20.00% |
| Series A shares issued | 2,500,000 | 2,840,625 |
| Post-money | 27,725,000 | 25,000,000 |
In the second column the new investor receives exactly the 20.00 per cent its 5,000,000 was meant to buy, and the existing holders' 10,000,000 shares are worth 17,601,760 rather than 20,000,000. The difference, 2,398,240, is exactly the value of the noteholder's shares at the new price. That is not a coincidence: when the note sits inside the pre-money, the existing holders pay for all of it, including the interest. This is the same mechanism as the option pool shuffle, explained in how the option pool shuffle lowers the effective pre-money. The cap price itself does not move, because the cap is computed on the pre-round capitalisation, which is why the note still converts at 0.80.
| Series A pre-money | Round price | Discount price | Conversion price | Binds | Shares | Multiple |
|---|---|---|---|---|---|---|
| 6,000,000 | 0.60 | 0.48 | 0.48 | discount | 2,270,833 | 1.36 |
| 8,000,000 | 0.80 | 0.64 | 0.64 | discount | 1,703,125 | 1.36 |
| 10,000,000 | 1.00 | 0.80 | 0.80 | both | 1,362,500 | 1.36 |
| 20,000,000 | 2.00 | 1.60 | 0.80 | cap | 1,362,500 | 2.73 |
| 40,000,000 | 4.00 | 3.20 | 0.80 | cap | 1,362,500 | 5.45 |
The crossover sits at a pre-money of cap ÷ (1 − discount) = 10,000,000. Below it the note is a discounted share purchase worth a fixed 1.36 times principal whatever the price; above it the share count freezes and the note's value rises one for one with the round. The cap is where the upside lives, which is why seed investors negotiate it harder than the discount.
| Months | Interest | Converting amount | Shares | Value at 2.00 |
|---|---|---|---|---|
| 12 | 60,000 | 1,060,000 | 1,325,000 | 2,650,000 |
| 18 | 90,000 | 1,090,000 | 1,362,500 | 2,725,000 |
| 24 | 120,000 | 1,120,000 | 1,400,000 | 2,800,000 |
| 36 | 180,000 | 1,180,000 | 1,475,000 | 2,950,000 |
A note that reaches maturity before a priced round does not convert automatically. Depending on its terms it is repaid, extended, or converted at the cap into common or a shadow series. Repayment is rarely possible at a seed-stage company, so maturity is in practice a renegotiation point, and an extension usually keeps the interest running.
Modelling the note as its principal. The interest converts too, and at the cap price every unit of interest buys 1.25 shares. A cap table built on 1,000,000 shows 1,250,000 note shares and misses 112,500. The second mistake is taking the Series A pre-money at face value without asking whether it includes the note: on this example that question is worth 2,398,240 to the founders, more than double the note's principal.
The cap table and conversion page, headline against reality, is one of the working documents in the free companion files for this book. For the post-money instrument that replaced many notes, see how a SAFE converts with a cap and a discount.
Usually yes. Most notes convert principal plus accrued interest at the conversion price, so interest is paid in shares, not cash. In the example 18 months at 6 per cent simple adds 90,000 to the converting amount and 112,500 shares, worth 225,000 at the Series A price of 2.00. Compounding annually instead would make the interest 91,337, a difference of only 1,671 shares.
No. The note converts at whichever gives the lower price, not both stacked. With an 8,000,000 cap on 10,000,000 shares and a 20 per cent discount, the two prices are equal at a pre-money of 10,000,000. Below it the discount binds; above it the cap binds, and at a 20,000,000 pre-money the cap price of 0.80 is half the discounted price of 1.60.
It depends on whether the Series A pre-money includes the shares the note converts into. If it does, the price falls from 2.00 to 1.76, the new investor still gets exactly 20.00 per cent for 5,000,000, and the founders' 20,000,000 headline is worth 17,601,760. The 2,398,240 gap is precisely the value of the note's shares at the new price.
This article is one calculation from The Venture Capital Associate. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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