In part-1 and part-2, we covered the basic definition of the convertible note and how the discount and cap work. Today we will look at the case when both discount and cap are applicable.

More often than not though, convertible notes have both a valuation cap and discount. In this case, the terms would be such that the conversion price would be the lower of the two scenarios (the price obtained by applying discount and the price obtained by dividing the cap by the valuation in the next equity financing round). The lower price helps the note owner gain more shares upon conversion.

In the previous examples, we saw that the discount gives the price of $0.1 per share of Series A preferred stock (20% discount) and the cap gives the price of $0.5 per share. Hence, the conversation price would be $0.5 in this case. Had the pre-money valuation been $6M (with a cap of $5M), then the price after discount would have stayed the same, but the cap would have given the price of $0.83 ($5M divided by $6M). In this case, the conversion would have been at the discount price. (Even though the pre-money valuation is more than the cap valuation). Thus, until the pre-money valuation is greater than $6.25M ($5M/unknown = $0.8), the cap price would not be used.

I will add one more point here. The interest in the case of a convertible note is not usually paid in cash like a normal loan. It keeps on accumulating and at the time of conversion, the accumulated interest is added to the principal amount, which is then used to obtain the number of shares. For example, if the interest rate is 5% on a $500k note and the next equity financing round occurs after one year, then conversion would happen on $525k. ($500k + 0.05*$500k)