A worked scenario valuation of a venture convertible note, with interest accruing to each event and conversion at the better of the cap and the discount.
A convertible note held by a fund is fair valued as the probability-weighted, discounted payoff of the ways it can end: conversion in a priced round, at the better of the cap and the discount on principal plus accrued interest, settlement at maturity, or a wind-down. An illustrative 2,000,000 note with 8 per cent interest, a 20 per cent discount and a 20.0m pre-money cap, one year into a two-year term, is worth 2,198,135, against 2,160,000 of principal and accrued interest. 86.0 per cent of that value comes from the two conversion scenarios.
Worked in full in The Private Markets Valuation Specialist by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Many venture funds carry notes at cost plus accrued interest until they convert. It is a convenient number and sometimes a close one, but it is a debt measure applied to an instrument whose value is mostly equity. A note pays interest in shares, not cash, in almost every outcome that matters, and the number of shares depends on the next round's price. Under investment company accounting the note is measured at fair value at each reporting date, and ASC 820 and IFRS 13 define fair value as an exit price: what a market participant would pay for the payoffs, not what the fund lent. With unobservable probabilities and recoveries driving the answer, it is normally a Level 3 measurement.
Three features separate a note from a SAFE, which is valued in how to fair value a SAFE held by a venture fund. The amount that converts grows with time, because interest accrues. There is a maturity date, which gives the holder a claim, however weak, if no round arrives. And the claim at maturity is often settled by negotiation rather than paid in cash. Each of those shows up as a scenario.
| Term | Value |
|---|---|
| Principal | 2,000,000 |
| Interest, simple, converts with principal | 8.0% |
| Time since issue / term to maturity | 1 year / 2 years |
| Principal and accrued interest today | 2,160,000 |
| Discount to the round price | 20% |
| Valuation cap, pre-money | 20,000,000 |
| Discount rate, risk-adjusted (illustrative) | 20% |
At a qualified round the note converts at the lower of the cap price and the discounted round price. Its shares are worth the accrued amount times the larger of 1 / (1 − 20%) = 1.25 and pre-money / cap. The cap is the better term above a pre-money of 25,000,000. The cap is applied to the pre-money here and the dilution from the note itself is ignored; the mechanics are in how a convertible note converts with interest.
Step 1: the payoff in each scenario. Interest keeps accruing until the event, so the amount converting in six months is 2,000,000 × (1 + 8% × 1.5) = 2,240,000, and the amount owed at maturity is 2,320,000.
Step 2: discount each payoff to today at 20 per cent: a factor of 0.9129 at six months and 0.8333 at one year.
Step 3: weight by probability and add.
| Scenario | Probability | Years | Payoff | Present value | Weighted |
|---|---|---|---|---|---|
| Round at 30.0m pre: 2,240,000 × 1.50 | 45% | 0.5 | 3,360,000 | 3,067,246 | 1,380,261 |
| Round at 16.0m pre: 2,240,000 × 1.25 | 20% | 0.5 | 2,800,000 | 2,556,039 | 511,208 |
| No round, settled at maturity: 60% of 2,320,000 | 25% | 1.0 | 1,392,000 | 1,160,000 | 290,000 |
| Wind-down: 10% of principal | 10% | 1.0 | 200,000 | 166,667 | 16,667 |
| Fair value | 100% | 2,198,135 |
FV = Σ pi × payoffi / (1 + r)ti
Conversion payoff = P × (1 + i × tevent) × max(1 / (1 − d), pre-money / cap)
In Excel: =SUMPRODUCT(Prob,Payoff/(1+r)^Years)
The note is worth 2,198,135, 1.099 times its cost and 38,135 above principal plus accrued interest. On these inputs the two numbers happen to be close, which is the trap: the closeness is a coincidence of the probabilities, not a property of the instrument. A pure debt view, 2,320,000 at maturity discounted at 20 per cent, gives 1,933,333 and misses that most of the value is in conversion.
| Pre-money, m | Conversion multiple | Value at conversion |
|---|---|---|
| 12 | 1.25 | 2,800,000 |
| 20 | 1.25 | 2,800,000 |
| 25 | 1.25 | 2,800,000 |
| 30 | 1.50 | 3,360,000 |
| 40 | 2.00 | 4,480,000 |
Below 25.0m the discount sets the payoff and the note is indifferent to the round price; above it every extra million of pre-money adds 112,000. That kink is why the probability of a strong round matters more than its exact price.
| Round above cap / maturity / wind-down | 15% | 20% | 25% |
|---|---|---|---|
| 60% / 15% / 5% | 2,592,393 | 2,533,889 | 2,479,084 |
| 45% / 25% / 10% | 2,252,150 | 2,198,135 | 2,147,653 |
| 30% / 35% / 15% | 1,911,907 | 1,862,382 | 1,816,222 |
The probabilities move the answer about seven times as much as the discount rate. Shifting fifteen points from a strong round to maturity and wind-down takes the value from 2,198,135 to 1,862,382, below cost; five points on the rate moves it by 50,482. Evidence on the round, a term sheet, a lead investor's interest, months of cash left, is what the valuation committee should be asking for.
Fair value = Σ probability × payoff / (1 + r)t, with interest accruing to each event and conversion at the better of the cap and the discount. Here 2,198,135, close to principal plus interest only by coincidence, and between 1,862,382 and 2,533,889 on reasonable probabilities. The calibration, scenario and roll-forward discipline behind it is in the free workbooks for this case.
Only if that happens to equal fair value. In the illustrative case cost plus interest is 2,160,000 and the scenario value is 2,198,135, but shifting fifteen points of probability from a strong round to maturity and wind-down takes fair value to 1,862,382, below the 2,000,000 lent. Fair value moves with the probabilities; accrued interest does not.
Usually yes: principal and accrued interest convert together. On a 2,000,000 note at 8 per cent simple interest, a round 18 months after issue converts 2,240,000. At a 1.50 conversion multiple the 240,000 of interest alone is worth 360,000 of shares.
When the round's pre-money exceeds the cap divided by one minus the discount. With a 20,000,000 cap and a 20 per cent discount the cap wins above 25,000,000. Below that the note converts at a 1.25 multiple whatever the price; above it each extra million of pre-money adds 112,000 on 2,240,000 converting.
This article is one calculation from The Private Markets Valuation Specialist. 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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