The Dilution Hiding in Convertible Note Interest
Convertible notes get modelled as though the principal is the whole story, and then the conversion schedule arrives with a larger number on it. Convertible note interest conversion is the reason. Unlike a SAFE, a note is debt: it carries a rate, that rate accrues for as long as the note is outstanding, and in most documents the accrued amount converts into equity rather than being repaid in cash.
Does the interest on a convertible note turn into shares?
Usually yes. Most convertible notes accrue interest that converts alongside the principal, so the investor receives shares for both. Eighteen months at eight per cent on a million dollars adds a hundred and twenty thousand dollars of conversion value nobody wired.
- Interest typically converts with the principal rather than being paid out in cash.
- Simple interest accrues on the principal only; compound interest accrues on interest too.
- The longer a note sits unconverted, the more shares its interest quietly buys.
What the accrual is worth
A $1M note at eight per cent simple interest, converting at an $8M cap eighteen months after signing, converts on $1.12M rather than $1M. At that cap the difference is 1.5 additional points of the pre-money company — more than most founders would concede knowingly in a negotiation, arriving instead as a line item at closing. Compounding, or a longer runway to the priced round, widens the gap further.
Because the note also carries a cap or a discount, the interest interacts with the conversion price rather than sitting beside it. The SAFE note conversion calculator models the cap-versus-discount decision that governs the conversion price, and the founder dilution calculator shows the resulting ownership once those shares are issued.
Two things to check before signing
First, whether interest converts or is repayable — a note that must be repaid in cash at maturity is a different instrument from one that converts, and founders sometimes discover which they signed at the worst possible moment. Second, whether the rate is simple or compounding, and what the maturity date does if the round slips. Lovie accrues note interest against the cap table as time passes, so the conversion figure is current rather than reconstructed the week of the round.
Accrual rules for discount on debt instruments are set out in 26 U.S. Code §1272 on accrued discount.