Let’s do a numerical example ignoring any accrued interest:
You invest $25k in a startup’s seed round using a convertible note with a $5M cap
At the Series A, the startup raises money from a venture capital firm that invests at a pre-money valuation of $10M with a per share price of $5.00
Your $25k loan would convert into shares of Series A Preferred Stock at a price of $2.50 per share ($5M cap divided by $10M pre-money valuation) which gives 10,000 shares of Series A Preferred Stock ($25,000 divided by $2.50/share); a new Series A investor would receive only 5000 shares of Series A Preferred Stock for $25k
On paper, your 10,000 shares at $5.00/share are worth $50,000 which is an unrealized return of 100%
If the pre-money valuation were higher at $20M, your $25k note would convert at $1.25/share ($5M cap divided by $20M) into 20,000 ($25k divided by $1.25) Series A shares worth $100,000 for a paper unrealized return of 300%.
[Reproduced from original source here: https://bit.ly/2H4ri4V]