What every founder should know about convertible notes and calculating cap tables

On September 1, 2012 by murat

What is a convertible note?

A convertible note is a short-term loan that doesn’t get paid back like a typical bank loan, but converts into preferred shares when the company raises an equity round of financing.

So, instead of a full-on equity round, investors loan money to a startup. And instead of just getting paid back with interest, they end up getting preferred shares upon the next equity round with some perks (like interest and discounts) that provide the incentive to do so.

There are tons of details and opinions on convertible notes, but here are the basics that every founder should know:

Conversion Discount:

A conversion discount is a mechanism to incentivize the investors for the convertible note, which enables them to receive more preferred shares than their money’s worth at the time of conversion. Discounts range from 10% to 35% with most common being 20%. Thus, investors receive equity equal to their investment / (1 – discount).

Below is a simple 3 step process (Thanks to Aaron Holiday, please see the end of the article) to price a Series A round with a convertible note:

(1)  Calculate the expected ownership for both VCs and convertible note holders

  1. VCs Ownership = VC Investment / Post Money Valuation
  2. Convertible Note Ownership = (Investment / (1 – discount))/ Post Money Valuation

(2)  Determine total number of new shares to issue:

  1. New Shares to Issue = ((VC + Convertible Note Ownership) / (1 – (VC + Convertible Note Ownership)) * Original Outstanding Shares
  2. Total Outstanding Shares = Original Shares + New Shares

(3)  Price / Share = VC Investment / VC Shares

  1. Notice, by calculating Debt Investment / Convertible Shares, we come up with a price that is automatically discounted by the discounted rate from the price of the round

Example 1) Seed investors put in $500K for a  note with 20% discount.

Later, the company raises $2M at $4M pre-money valuation.

Assuming 1M outstanding shares before the Series A round:

(1)  Total New Ownership

  1. VCs Ownership = $2M / $6M = 33.33%;
  2. Convertible Note Ownership = ( (500K / (1 – .20) ) / $6M = 10.42%
  3. Total New Ownership = 33.33% + 10.42% = 43.75%

(2)  New Shares to Issue

  1. ( (43.75% / (1 – 43.75%)) * 1M Shares = 777,777 Shares
    1.                                           i.    VC Shares = 592,592
    2.                                          ii.    Convertible Debt Shares = 185,185

(3)  Price / Share

  1. $2M / 592,592 Shares = $3.37 per share
  2. 500K / 185,185 =$2.70 per share (notice $3.37 discounted by 20% is $2.70)

Final cap table:

Founders                     1,000,000 shares        56.25%

Seed investors               185,185 shares        10.42%

Series A investors          592,592 shares        33.33%

Total                             1,777,777 shares        100.0%

(Notice, in this scenario the convertible note dilutes the founders but not the Series A investors)

Example 2) With everything exactly the same as Example 1 but with the company raising $2M at $6M valuation.  Assuming 1M outstanding shares before the Series A round

(1)  Total New Ownership

  1. VCs Ownership = $2M / $8M = 25%;
  2. Convertible Note Ownership = ( (500K / (1 – .20) ) / $8M = 7.81%
  3. Total New Ownership = 25% + 7.81% = 32.81%

(2)  New Shares to Issue

  1. ( (32.81%/ (1 – 32.81%) ) * 1M Shares = 488,372 Shares
    1.                                           i.    VC Shares = 372,093
    2.                                          ii.    Convertible Debt Shares = 116,279

(3)  Price / Share

  1. $2M / 372,093 Shares = $5.38 per share
  2. 500K / 116,279 =$4.30 per share (notice $5.38 discounted by 20% is $4.30)

Final cap table:

Founders                      1,000,000  shares        67.19%

Seed investors                116,279  shares          7.81%

Series A investors           372,093  shares        25.00%

Total                             1,488,372  shares         100.0%

As you can see, seed investors are getting less of the company at conversion as the post-money valuation of the company is increasing, which misaligns the seed investors and the company. To fix this problem, conversion caps are used.

Conversion Cap:

To provide protection against too much upside, investors put a ‘price cap” on a convertible note. This means that even if the company valuation goes sky-high in the next round, the investor gets his loan converted at the “cap” valuation. This cap is expressed in terms of pre-money valuation and effectively is a share price ceiling.

A convertible note investor will either exercise the right to buy Series A shares at the convertible note discount price or exercise the right to receive equity in the company that is equity to the implied ownership derived from the seed investment divided by the conversion cap diluted by the Series A investors.

Below is a basic 3 step process to follow to determine the price and best conversion decision for a convertible note with both a discount and conversion cap.  When following these steps, we do a side by side analysis discount price vs. cap.  An example is provided below.

(1)  Calculate the expected convertible note:

  1. Ownership using the discount (see above step # 1)
  2. Expected Ownership Using Cap = ((Investment Amount) / (Conversion Cap) )* (1- VC Ownership).  See step 1 above for VC Ownership

(2)  Issue new shares using VC Ownership + Expected convertible note ownership. 

(3)  Price / Share = VC Investment / VC Shares

  1. Discounted price = Convertible Debt Investment / Convertible Debt Shares
  2. Find the percentage decrease from price / share to discount price to find the effective discount

 

Example 3) Seed investors put in $500K for a note with 20% discount and a $4M cap.

Later, company raises $2M at $4M pre-money valuation.

Assuming 1M outstanding shares before the Series A round:

In this example, it is clear that the best option for the investors is to exercise the discount over the conversion cap option.

 

Example 4) With everything exactly the same as Example 3 but with the company raising $2M at $6M valuation and assuming 1M outstanding shares before the Series A round:

As you can see in this example, seed investors are protected against extreme downside as the company’s valuation grows.

 

Bonus Example 5) With everything exactly the same as Example 4 but with the company raising $2M at a much higher $10M valuation and assuming 1M outstanding shares before the Series A round.

As you can see, now seed investors and the company are properly aligned.

 

Interest Rate:

This is a simple interest on the amount of the loan, usually between 5-10%, with 8% being the most common. But this interest is not paid in cash on a periodic basis like a typical loan but is added to the conversion amount when the note converts.

For example, on a $500K note with a 5% interest rate, the amount that converts after a year would be $525K, which is $500K + $25K in interest(5% of $500K).

 

Maturity Date:

Just like a regular loan, convertible notes have a due date when the borrowed amount plus interest should be paid back, if the presumed equity round does not happen. (Equity rounds trigger automatic conversion of the note into preferred stock).

Maturity date is usually 12 to 24 months from the closing date, with 18 months being the most common.

So what happens when the maturity date is reached and the company doesn’t raise an equity round? The seed investors may call the loan and force the company into bankruptcy, but that  doesn’t really work for anyone. There are usually two outcomes in this situation:

1) Automatic conversion: The loan amount plus interest convert into common or preferred stock at a previously agreed upon valuation which is called a floor.

2) Negotiating an extension: This is more common and obviously depends on the company’s leverage and the investors’ positions.

 

Note: Big thanks to Aaron Holiday, who is working with ERA this summer, for major contributions to this post, as well as the great three step process he had come up with. Follow Aaron on his blog: http://www.aholidayiii.com/

 

Disclaimer: There are option pool adjustments, interest, multiple notes with different terms and many other terms that complicate cap table calculations, but hopefully this gives you a handle on how to negotiate and raise convertible notes. Definitely work with a lawyer. I am not a  lawyer :)

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