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Random freezes, missing sound and display glitches usually trace back to one bad driver. Find and replace yours safely.Free scan · under a minutePrepaying a convertible note can reduce the amount that converts into shares, but it consumes cash and may shorten a company’s operating runway. Letting the note convert usually preserves cash in the short term while diluting existing shareholders. The actual outcome depends on the signed note’s prepayment, interest, conversion, maturity and transaction terms—not on a universal rule.
What a prepayment changes
A convertible note is debt with terms that can allow or require conversion into another security, typically shares. The U.S. Securities and Exchange Commission’s Investor.gov describes a convertible security as one that can be converted into a different security, usually common stock: SEC Investor.gov: Convertible Securities. While a note remains outstanding, principal and possibly interest remain obligations; the agreement determines whether and when they are repaid or converted.
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If the company is allowed to prepay, cash payment can extinguish some or all of the balance that otherwise might convert, reducing the shares issued on that note. But the company must fund the contractually required amount—potentially principal, accrued interest, premiums or fees—leaving less cash for payroll, product development and other operations. Conversion generally avoids that immediate repayment outflow, but the resulting shares dilute existing owners.
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Prepayment does not necessarily prevent all dilution. New financing shares, other convertible notes or SAFEs, option grants, and changes to an option pool can also affect ownership.
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Which contract terms determine the result?
Read the executed note and all amendments. The following provisions determine whether prepayment is possible, what it costs and how conversion is calculated. The cited SEC-filed agreements are examples of differing terms, not standard terms that apply to every note.
Prepayment right and required consent
Check whether the company has an optional prepayment right, whether holder or majority-holder consent is required, and whether the rules change after a financing, default or change of control. One SEC-filed example bars prepayment before maturity without majority consent; another sample term sheet calls for written approval from the requisite noteholders for ordinary prepayment. Those examples illustrate why the signed agreement—not an assumption that a borrower can repay at will—controls. SEC-filed note example; SEC-filed term sheet example.
Amount and timing of payment
Identify the amount due on the proposed payment date, including principal, accrued interest, any default interest, premiums and fees. A sample corporate-transaction provision gives a holder choosing cash rather than conversion accrued interest plus twice the principal. That is a particular contractual example, not a general prepayment formula. SEC-filed term sheet example.
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Conversion trigger and price
For conversion scenarios, locate the qualified-financing threshold, discount, valuation cap, capitalization definition and any rule selecting the lower of multiple price calculations. In one filed example, principal and unpaid accrued interest convert at the lesser of a discount price or a valuation-cap price. A lower conversion price generally produces more shares for the same converting balance. SEC-filed note example.
Interest treatment
Determine whether accrued interest is paid in cash, converts with principal, or receives different treatment depending on the event. If interest converts, it increases the balance used to calculate potential shares. If paid in cash, it increases the immediate funding requirement. The sample agreements treat interest differently in different circumstances, so use the clause for the specific event being modeled.
Maturity and company-sale provisions
At maturity, the note may call for repayment, extension, optional conversion or mandatory conversion, depending on its language. A defined sale, merger or other change-of-control event may create separate choices or payment obligations. For example, one sample term sheet lets a holder elect conversion or a specified cash payment after a defined corporate transaction. Confirm how the agreement defines the event and who holds the election. SEC-filed term sheet example.
Compare the alternatives with a cash and cap-table model
Model only alternatives actually permitted by the agreement. A useful comparison includes prepayment now (if allowed), conversion in a qualified financing, and the applicable maturity or transaction outcome if the note remains outstanding.
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- Runway: Apply the company’s current burn assumptions to the post-payment cash balance. State the assumptions and period used; runway is not a fixed property of the note.
- Shares and ownership: Calculate shares issued under the note’s conversion formula, then show post-transaction ownership.
- Accrued balance and exposures: Include interest through the relevant date, required consents, premiums, and any default consequences that could apply.
- Other dilution: Model financing shares, other notes and SAFEs, options, and any option-pool change separately from the note’s own conversion effect.
Do not estimate ownership from a valuation cap alone. The conversion-price formula, balance at conversion, defined capitalization, financing terms and other securities all matter. Without the executed terms, capitalization and cash forecast, there is no defensible generic dilution percentage or runway result.
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When falling share prices can increase dilution
Some instruments use a market-price discount in their conversion formula. The SEC warns that when conversion is tied to a discounted market price, a falling share price can mean more shares are issued, increasing dilution and potentially complicating later financing. This concern is especially relevant to some public-company instruments; it should not be assumed to describe every startup note with a valuation cap. SEC Investor.gov: Convertible Securities.
Accounting is a separate question
The cash-flow decision does not by itself determine the accounting entry. IAS 32 materials describe liability and equity components for certain compound financial instruments and address early redemption or repurchase. HM Revenue & Customs’ worked example for a three-year £1 million convertible bond with 5% annual interest and a 7% comparable non-convertible market yield calculates a £947,513 liability component and a £52,487 equity component. Those figures illustrate that example’s assumptions; they are not a forecast or an accounting answer for a startup note. IAS 32; HMRC Corporate Finance Manual CFM21270.
The accounting for a particular note depends on its exact terms, jurisdiction, reporting framework and applicable current standards. In particular, do not assume the entire early repayment is automatically an expense or that every early redemption receives identical balance-sheet treatment.
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