Calculate Your Convertible Note's True Dilution Before You Sign
The real cost of a convertible note is the lowest conversion price created by discount, interest, and cap, not the discount alone.
The trap: the discount is not the whole bill
You are about to sign, and the trap is simple: the discount is not the whole bill. Founders often read convertible instruments as a small favor: a modest discount, a cap that feels protective, and a promise that the real pricing conversation can wait. The conversion terms are shaped by the discount and valuation cap. The discount rate is only one input. The valuation cap is another. Accrued interest is the quiet third, and it can turn a small bridge into a meaningful founder dilution event.
When you sign the instrument, you are not just borrowing cash. You are agreeing to a conversion price that may be lower than the price paid by the next round of investors. That lower price is what creates extra shares. The extra shares come out of the same pie your founders, employees, and future investors will share.
The rule: the instrument converts at the lower price, on the enlarged principal
First, a discount on a convertible instrument gives the holder a percentage off the priced round's share price, but it matters only when it produces a lower conversion price than the valuation cap, and accrued interest adds to the conversion amount. Then, every one of these instruments states that the holder converts at whichever price is lower: the cap price or the discounted price. Finally, accrued interest is not paid in cash; it is added to principal and the enlarged principal converts into shares. The conversion math should use principal plus accrued interest, apply the discount, then compare against the cap. If a no-cap instrument has a 20% discount and the next round prices at $10 per share, it does not convert at $10; it converts at $8 per share, because the holder gets the discounted price. Most of these instruments accrue interest at 2-8%, and that interest converts into shares too, so an 18-month instrument can hand holders 10-15% more stock than the cash they wrote the check for. That is why a convertible instrument that looks like a small bridge can become a second, hidden round of financing. The company still receives the same cash, but the holder receives more shares for that cash. That is dilution in its simplest form. A convertible instrument is not a loan with a small sweetener; it is a pre-priced equity purchase with a delay. The delay is useful, and the pre-pricing is the part that changes your cap table.
The Instrument Dilution Check
Before you sign, run the same math the investor will run at conversion. Do not stop at the discount. Do not stop at the cap. Do not stop at the original check size. The number that matters is the enlarged principal, converted at the lowest allowed price.
- Add accrued interest to principal, because the instrument converts on the enlarged amount, not the original cash.
- Calculate the discounted price as the next round price times one minus the discount, because that is the price the investor would get if the discount beats the cap.
- Use the lower of the discounted price and the cap price as the conversion price, because the instrument does not choose the friendlier number.
- Convert the enlarged principal into shares at that conversion price, because that tells you how many shares the instrument actually buys.
- If the instrument includes a pro rata right, model the extra shares in the next round as additional founder dilution, because the instrument is not the only conversion event and the follow-on right can be the second one.
Keep the output simple: shares issued, founder ownership before, founder ownership after, and the cash you actually raised. Put the result next to your existing cap table, not in a separate spreadsheet. The instrument's shares should appear as a new line, and the founder percentage should be recalculated after conversion. If the instrument is the only bridge, the math is simple. If it is one of several instruments, the same check applies to each instrument, and the combined effect is what matters.
Run the check, keep the number on the whiteboard, and sign only when the true dilution is visible. If the after number is lower than you expected, the instrument is more expensive than the term sheet suggests. If it is close, you have a defensible bridge. If it is far off, you need to renegotiate the cap, the discount, the interest, or the pro rata right. Run the check, keep the number on the whiteboard, and sign only when the true dilution is visible.
