How Can a Conversion Cap Affect Ownership When a Loan Turns Into Shares?
Short answer. A conversion cap limits the valuation used to calculate the loan's share price, even if a later financing values the company higher. That can give the lender more shares for the same loan balance and increase dilution for existing owners. Model the terms against plausible financing outcomes before signing.
A conversion cap can increase the number of shares a lender receives when a loan converts. It sets a maximum company valuation for calculating the conversion price, so a later financing above that cap may not determine the lender's price. The lower conversion price can translate into a larger ownership stake and greater dilution for founders and existing shareholders.
Understand How the Cap Works
Read the agreement to see exactly which valuation the cap limits and how it applies to the conversion calculation. Check whether the cap uses a pre-money or post-money basis, what securities and share counts are included, and whether accrued interest converts along with principal. The words in the agreement matter because small differences in the calculation can change the number of shares issued.
A convertible loan may also include a discount to the price in a future financing. Determine whether the lender receives the lower price under the cap or discount, or whether the agreement uses another formula. Do not assume the cap and discount operate in a particular way from a summary description.
Model the Ownership Effect
Ask your finance lead or adviser to calculate the share issuance under different future valuations, financing sizes, and conversion dates. Include the loan balance, accrued interest, current shares, option pool, and other instruments that may convert. Compare the outcomes with and without the cap, then review how much ownership remains for founders and current holders.
The direct deal return calculator is useful for framing investor return scenarios, and the guide to dilution across funding rounds can help you consider the wider ownership picture. These tools do not replace a cap table built from the actual documents.
Connect the Cap to the Full Agreement
Review the cap alongside the interest rate, maturity, repayment rights, conversion triggers, and any discount. The agreement should say what happens if no qualifying financing occurs, whether the lender can demand repayment, and how the conversion price is determined in each scenario. Also check how the conversion affects voting and other rights after shares are issued.
Ask the lender to walk through examples using the same assumptions you use internally. Have your attorney review the drafting and talk with your CPA where tax treatment matters. A cap can be a reasonable part of a financing agreement, but you need to understand how it changes ownership before accepting the loan.
Read next: What should founders consider before accepting a convertible loan?
Convertible notes are typically when you're investing in an early -stage company, and that company's like, you know, it's very hard to put a value on the company right now, so let's just kick that down the road.
Sources: Richard C. Wilson solo transcripts, The Single Family Office. Informational only, not financial, legal or tax advice.