How to set convertible note cap fairly?

We're a software startup and are raising a convertible note seed round. The investors insist on having both a discount and a cap. I have a pretty good understanding of how the discount works but don't know how to come up with a cap that's fair.

Say we are raising $200k right now and value ourselves at $800K pre. We do intend to raise a series A later (say $5M). Given a 20% discount, what's the ballpark range for a cap?

Strictly speaking 'fair' for the cap on the convertible note will be 'feels fair for both parties'.

You could set the cap at $800K, which says 'we are treating the convertible note as if it were an equity investment today, only leaving you the protection of a note'. You could set the cap at $4M which says 'we are treating the convertible note as a loan today, and we will pay back the note on the next round and then let you invest at a 20% discount'.

So the range is $0.8 - 4.0M.

If it's a friendly relationship, where you really trust the investor (i.e., they aren't going to get much benefit from holding the note) go towards the lower half of it, so say between $1.2-2.0M is a good range. If the investor is sophisticated, and there is a significant probability that they will use the note structure to take control of the company, they are really getting a big advantage from the note, so the conversion can be pushed upwards, to the $2-3M range.

Remember, they always get the 20% discount on the next round anyway, so having a $1M vs. $3M cap isn't that much of a big deal. If the cap figure is wrong, they will use the discount clause rather than the cap clause. It's really an option clause, which benefits them, and is something that can be negotiated over a wide range.

And there is no strict formula beyond those guidelines.