Your Practical Guide to Convertible Notes: Caps, Discounts, Dilution, and Legal Traps

Founders are often handed a “standard” convertible note and rushed to sign—pause. Don’t treat “standard” as safe: terms vary and can reshape ownership.

A convertible note is a short-term loan that converts into equity at the next priced financing, often using a discount or valuation cap.

This practical guide links to deeper dives on valuation caps, interest, liquidation preferences, and how SAFEs compare (plus hybrid-structure resources).

• What: short-term debt that converts to equity on a future priced round.
• Key terms: cap, discount, interest, maturity and conversion triggers — these determine dilution and exit outcomes.
• Why counsel: lawyers model cap‑table effects, negotiate market terms, and catch harmful maturity or exit provisions.

A convertible note is short‑term debt that converts into equity in the next priced financing (typically using a discount or a valuation cap) rather than being repaid in cash.

Unlike a traditional loan—which expects cash repayment—or a priced equity round—where shares and valuation are fixed now—a note defers valuation. Common uses: early-stage raises, bridge financing between rounds, and small‑business growth capital.

Example: you raise $250,000 on a note with a 20% discount. If Series A sets a $5M pre‑money valuation, the note converts as if the valuation were $4M—investor gets ~6.25% vs 5%.

Benefits: faster closings, lower upfront legal cost than a priced round, and flexibility when valuation is uncertain. Risks: hidden dilution (see fully diluted share issues), misaligned expectations, maturity pressure if no round occurs, and legal complexity—bring counsel early.

Don’t treat note terms as boilerplate—each clause can change your economics and control.

Principal amount and funding mechanics

Principal is the cash an investor lends; multiple notes aggregate into total convertible debt. Closings may occur in tranches and sometimes require minimum commitments before conversion mechanics apply.

Interest rate and accrual

Interest usually accrues (not paid in cash) and converts with principal — e.g., 6% on $250,000 for 18 months ≈ $22,500 added to the conversion amount. See our deep dive on interest: understanding convertible‑note interest rates.

Discount rate

A 20% discount converts at 80% of the Series A price per share, which yields roughly 25% more shares than converting at full price.

Valuation cap

The cap sets a maximum valuation for conversion; for example, a $5M cap in a $10M Series A typically gives note holders about twice the shares versus an uncapped conversion. Read more on caps: understanding convertible‑note caps.

Maturity date

Typical maturities are 18–24 months. At maturity the company and investors can extend, repay, or convert according to the note’s default provisions.

Conversion triggers and mechanics

Conversion usually happens on a “qualified financing” (a future equity round above a set threshold); the conversion price is the lower of the cap‑implied price or the discounted Series A price. For legal mechanics and examples, see our convertible notes guide: convertible notes — a legal guide.

Caps and discounts are the levers that determine how much of the company you give away later — small differences matter.

Example 1 — uncapped, 20% discount: If a Series A values the company at $10M, a 20% discount converts the note as if the valuation were $8M. A $250,000 note therefore becomes about 250,000/8,000,000 = 3.125% (~3.1%). At the Series A price without a discount that $250k would buy 2.5% — the discount yields roughly +0.6 percentage points.

Example 2 — $5M cap + 20% discount: The cap is the lower benchmark, so conversion uses $5M: 250,000/5,000,000 = 5% ownership — materially more founder dilution than the uncapped example.

Multiple notes with different caps/discounts “stack” at different effective prices; lower caps take larger stakes and can surprise founders at Series A. Model scenarios in a spreadsheet and have counsel sanity‑check assumptions. For a deeper walk‑through on caps, see Valuation Cap for Startups and Businesses.

Interest on convertible notes usually accrues and is added to the principal that converts into equity; cash interest payments are uncommon. Example: 6% on $250,000 for 18 months adds roughly $22.5k to the conversion amount.

At maturity (commonly 18–24 months) the usual options are: agree an extension, repay principal plus accrued interest, or convert per the note’s conversion terms. If you can’t repay, the note can behave like real debt—creating collection risk or operational strain.

Founder‑friendly fixes include automatic extension windows, conversion rather than cash repayment, or capped post‑maturity rates; investor‑friendly terms often raise interest on extension or add repayment priority. Lawyers help draft clear extension/amendments, negotiate market‑reasonable rates and mechanics, and align outcomes with your runway—see the interest-rate overview here: SAFE vs Convertible Note.

Liquidation event = sale, asset sale, merger or IPO that triggers distribution of proceeds.

Many notes say what happens if a sale occurs before conversion: either a cash‑out (often 1x principal + accrued interest) or conversion into equity and participation in proceeds. The choice greatly affects payout priority.

If a note later converts in a priced round, converted holders usually take the liquidation rights of that preferred stock (e.g., 1x preference), which alters who gets paid first.

Light example: company sells for $3M; $250k note. A 1x cash‑out gives the investor $250k; conversion at a $5M cap (~5% equity) yields ≈$150k — materially different.

Poorly drafted clauses can skew exits. For a deeper legal breakdown see: Navigating Convertible Note Liquidation Preferences.

SAFEs (Simple Agreements for Future Equity) are simple contracts that promise equity later without setting a valuation now; they’re popular because they speed closings and lower upfront legal cost.

• Convertible note: debt (interest + maturity), converts at a future priced round (caps/discounts); gives investors creditor protections and moderate document complexity.
• SAFE: contract for future equity, typically no interest or maturity—simpler and faster but can create cap‑table surprises.
• Priced equity: shares issued now at a negotiated valuation—most complex and expensive upfront, but fixes ownership and investor rights.

Choose a note when investors want creditor protections, accrued interest, or a formal repayment fallback; choose a SAFE when speed and low cost matter. For hybrid options see Convertible Shares for Startups and Businesses, and for a detailed comparison see Convertible Note vs SAFE — a legal comparison.

Think of counsel as your fundraising partner — they pick the right instrument, negotiate terms, protect ownership and speed closings.

Align

Lawyers pick note/SAFE/priced round by stage and runway, and align caps, discounts and maturity. See: Convertible Notes — guide.

Negotiate

Counsel sets market ranges, flags MFN/broad protections and bad defaults, and negotiates extension mechanics.

Protect cap table

They model conversions, coordinate multiple instruments and pro‑rata rights to avoid surprise dilution.

Close & support

Lean, jurisdiction‑tailored templates and consistent documents, plus help with extensions and pre‑round cleanup.

Checklist:

• Best instrument?
• Cap/discount → modeled dilution?
• Maturity and extension plan?
• Default/control risks?
• Exit/liquidation treatment?

A liquidation event is a sale, merger, asset sale or (less commonly) IPO that triggers distribution of proceeds to stakeholders.

Many notes specify treatment if a sale happens before conversion: a cash‑out (often 1× principal plus accrued interest) or conversion into equity followed by participation in proceeds. That choice changes who is paid first and how much they receive.

When notes convert in a later priced round, converted holders typically receive the liquidation rights of the new preferred shares (e.g., a 1× preference), which can subordinate common equity.

Example: company sells for $3M and an investor holds a $250k note. A 1× cash‑out returns $250k; conversion at a $5M cap (~5% equity) would yield ≈$150k — a material difference.

Poorly drafted exit clauses can skew outcomes; have counsel review. For a deeper legal breakdown see Navigating Convertible‑Note Liquidation Preferences.

Convertible notes are flexible but carry real economic and legal consequences—don’t sign a “standard” form without checking caps, discounts, interest, maturity, conversion triggers and exit treatment.

• Model dilution under multiple scenarios (cap, discount, stacking).
• List the exact terms you’ve been offered (cap, discount, interest, maturity, liquidation treatment).
• Have counsel review your model and the note before committing.

Promise Legal can (a) review a proposed convertible note or SAFE, (b) design a fundraising strategy and instrument suite, or (c) clean up and consolidate outstanding notes before a priced round. Learn about our business services: https://promise.legal/practices/business and read our practical guide to notes: https://blog.promise.legal/startup-central/convertible-notes-for-startups-and-businesses-a-legal-guide/.

Early, thoughtful legal input reduces risk, protects founder ownership, and smooths future financings.