In the previous post, we covered the basic definition of the convertible note and how the discount works.

The other variation is with a “cap”. A cap is a maximum valuation that the investor/debt owner will pay, irrespective of the valuation of the round in which the conversion happens.

For example, the note owner wants to invest $500k in your startup and thinks that the pre-money valuation is in the range of $4-5M. The note owner and the founder(s) agree on a $5M valuation cap. After a year, when you raise your series A, the startup receives a pre-money valuation of $10M and the price is $1 per share for Series A preferred stock. In this case, the note owner will get shares at a price of $5M, that is, at a price of $0.50 per share of Series A preferred stock. Hence, the note investor will receive 1M Series A shares. (2x return excluding the interest on the loan).

If there was no cap and just a discount of 20% then this would have led to just a 1.25x return. A “cap” is similar to a valuation in a priced round. In some cases, caps might impact the valuation of the next round as the future investor might view it as a ceiling. However, caps also create more alignment in terms of the interests of the investors and the founders.

More often than not though, convertible notes have both a valuation cap and discount and will convert using whichever method gives the investor a lower price per share. We will cover this in the next post.