Convertible notes are originally structured as debt investments but have a provision that allows the principal plus accrued interest to convert into an equity investment at a later date. This means they are essentially a hybrid of debt and equity. A valuation cap is a hard cap on the conversion price for note holders regardless of the price per share on the next round of equity financing. Any automatic conversions that occur at the maturity date (if no qualified financing have occurred) are at some price per share that is lower than the cap. Convertible notes are debt instruments that include terms like a maturity date, an interest rate, etc., but that will convert into equity if a future equity round is raised. The conversion typically occurs at a discount to the price per share of the future round.
The answer to your question lies in the pros and cons of convertible notes, which will give you a clear idea what will happen to convertible notes if a company fails.
Pros:
i. Convertible note financings are simpler to document from a legal perspective. This means that they are generally less expensive from a legal perspective and that the rounds can be closed more quickly. The reasons for this are simple, being that the company and the investors are putting off some of the trickier details to a later date. In most equity financings, numerous corporate documents need to be updated to close the round such as certificates of incorporation, operating agreements, shareholder agreements, voting agreements, and various other items. All of this adds to the time and expense of completing a round of equity funding.
ii. Raising a convertible note as opposed to equity allows the company to delay placing a value on itself. This is particularly attractive to seed-stage companies that have not had time to show much traction in terms of their product and/or revenue. In exchange for giving investors a discount on the price that is set later, the company is able to push that decision to a later date. Because of this, convertible notes are often used as the first outside funding invested in many companies, and many institutional seed investors such as 500 Start-ups exclusively use convertible notes in their accelerator investments.
iii. For a variety of reasons, many companies need to raise some amount of funding between larger rounds of equity, and the features of a convertible note make it an ideal vehicle to complete those types of transactions. For example, one company that I have worked with had a transformational software deal with a large enterprise customer that was set to close. The company would need to ramp up its staff in order to service the new customer, and was planning to raise a new round of equity once the deal was signed; however, they could not disclose the specifics of the deal until that time. In order to get a jump, start on the work once the deal closed, the company wanted to raise a smaller amount of funds via a convertible note as it would allow the funding to close more quickly. It would also allow the company to delay the valuation decision for the equity round, as that would likely be more favourable once they were able to disclose the full details of the new contract.

Cons:
i. While there are many reasons why companies and/or investors choose to utilize convertible notes, both sides of the deal really need to think through the potential future implications of using this method of financing. The biggest issue that I have seen with seed stage companies is the question of what happens if the company cannot, or chooses not, to raise subsequent equity financing. While many convertible notes do include provisions for an automatic conversion on maturity, many do not. Given that we are mostly discussing very early stage companies, most of these companies are burning cash, and will not have the funds to repay the note at maturity if it does not convert. The best way to avoid this situation is for both the company and investors to have a clear plan for both success and failure. In most cases, if a company cannot raise additional funding past an initial convertible note seed investment, it is because the company does not have traction and will either end up going out of business or being acquired for a nominal amount. One interesting example from my work involves a company that received a seed investment in the form of a convertible note from a start-up accelerator, and was not able to raise additional equity funding, but was able to gain enough traction to continue operations and get to cash flow breakeven. The company did not have nearly enough cash to repay the note, but it was not going out of business either. However, if the investor foreclosed on the company, it would have essentially put the company out of business and guaranteed that their investment would be worth nothing. This left both the company and the investor in an awkward position that took several years to get resolved.
ii. The awkward situation of the company described in the preceding anecdote can be avoided by negotiating the terms of an automatic conversion at the maturity of the note. However, if you go too far down the road of defining what that next round looks like in regards to all of the terms and provisions that would be included in a typical equity round you actually lose some of the benefits of using a convertible note in the first place. One example related to a company that I have worked with involving a promising software startup that was graduating from an accelerator program. It had a basic product, some name brand clients had already signed contracts, and the company had attracted potential investors. They chose to fund the round with a convertible note, but given that the note may have been enough funding to take the company past the maturity date, they wanted to know what their investment would be like if that happened. As it turned out, this led down the road to negotiating exactly what the specific terms of that equity round would look like, and the company ended up spending as much on legal fees as if they had just done the equity round to begin with.
iii. Most convertible notes issued in seed funding scenarios at this point in time include a valuation cap and an automatic conversion price. While you are technically delaying putting a price on the company, oftentimes the cap and conversion price effectively acts to anchor the price negotiations of the next round. Even if investors are willing to pay for a big uptick in valuation from the note valuation cap, you can end up with some very strange situations. For example, if the subsequent round of equity is preferred stock with a liquidation preference equal to the price per share of that round, convertible note holders can end up with a liquidation preference of several times their investment if there is a large uptick in valuation. In situations like this, the new investors may try to force the note holders to adversely amend their terms to close the deal.

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