Early-stage companies frequently raise money using instruments that avoid setting a share price. Understanding what is being deferred, and on what terms, is the substance of these agreements.
Valuation is the difficult negotiation
Pricing a company with little revenue and no comparable history is largely guesswork, and both sides know it. Agreeing a figure consumes time and can end a discussion entirely.
Convertible instruments sidestep this by taking the money now and converting it into shares later, at a price established by a subsequent priced round.
The investor is effectively agreeing to accept whatever valuation the next set of investors negotiates, with adjustments in their favour for having come in earlier.
Discounts and caps set the adjustment
A discount converts the early money at a reduction to the later round's price, compensating the investor for the additional risk taken at an earlier stage.
A cap sets a maximum valuation for conversion regardless of what the later round agrees, which protects the early investor if the company's value rises sharply.
Where both apply, conversion typically uses whichever produces the better outcome for the investor, so the two mechanisms operate together rather than as alternatives.
Debt and non-debt forms behave differently
A convertible note is legally a loan, which means it may accrue interest and have a maturity date at which repayment can in principle be demanded.
Other instruments are structured as agreements for future equity and are not debt, so no repayment obligation exists if a qualifying round never occurs.
The legal characterisation, its accounting treatment and its enforceability differ by jurisdiction, and the same document does not necessarily behave identically in two countries.
Dilution is deferred, not avoided
Founders often perceive these instruments as cheaper because no shares are issued at the time. The shares are issued later, and the amount is determined by terms agreed now.
Where several instruments accumulate with different caps and discounts, the combined conversion at the next round can be considerably larger than founders anticipated.
Modelling the fully converted position before signing each new instrument is the only way to see that, and it is a calculation that is easy to postpone.
The maturity date is a real constraint
Notes that reach maturity without a qualifying round leave the company holding an obligation it usually cannot repay, which puts the holder in a strong negotiating position.
Outcomes at that point range from extension to conversion at a default valuation, and which applies depends entirely on what the document specifies.
This is why the maturity term deserves as much attention as the cap, despite receiving far less of it in most early negotiations.