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Convertible notes are a popular way for early-stage startups to raise capital quickly. These notes are essentially short-term debt instruments that convert into equity, typically during the next financing round. While convertible notes may seem simple, their conversion process requires careful attention and understanding. This article walks through a realistic scenario a founder might encounter after raising capital through convertible notes.

You can download the Excel model to follow along better here. Note that Iterative Calculation needs to be enabled for the model to work properly.

Term Sheet Language

Before modeling the cap table, founders should pay close attention to the term sheet language regarding how the notes will convert. The language is typically phrased like the following:

Conversion: Upon the Company’s next sale of its Preferred Shares in a single transaction or in a series of related transactions, each occurring on or before the Maturity Date, for an aggregate gross purchase price paid to the Company of no less than $[XXX] (excluding the principal amount of and accrued interest on all Notes and other convertible securities converted in such sale) (the “Qualified Financing”), the entire balance then outstanding under each Note shall automatically be converted into shares of the Company’s capital (the “Note Shares”) issued simultaneously with the issuance and sale of the Company’s preferred shares in the Qualified Financing at a conversion price equal to the lesser of (i) [100% less the Discount Rate]% of the lowest per-share selling price in the Qualified Financing; and (ii) the price per share obtained by dividing (A) $[Valuation Cap] by (B) the number of common share equivalents of the Company outstanding immediately prior to the Qualified Financing (assuming conversion of all securities convertible into Common Shares and exercise of all outstanding options and warrants, including all Common Shares reserved and available for future grant under any equity incentive or similar plan of the Company, and/or any equity incentive or similar plan to be created or increased in connection with the Qualified Financing, but excluding the shares of equity securities of the Company issuable upon the conversion of the Notes or other indebtedness) (such lower price, the “Conversion Price”).

Pay particular attention to the highlighted part above about the conversion price. In simple terms, what this means is that the notes will convert at a discount to the future valuation or at a capped valuation, whichever is more favorable to the note investor.

Scenario

Let’s explore how the notes will convert in detail using an example.

ABC Inc. is a startup with 10 million shares outstanding at inception. The founders own 9 million shares, while 1 million shares are reserved for employee stock options. Last year, the company raised $100,000 from an angel investor through convertible notes. The notes stipulate a valuation cap of $4 million, a discount of 20%, and an interest rate of 10%.

This year, the company is raising a seed round and has received a term sheet for a $2 million investment at a $6 million pre-money valuation. The investor wants a 25% stake in the company post-financing and requires the option pool to be increased to 15% upon closing.

The founders want to know what the cap table will look like upon note conversion and post-seed round. What will be the dilution impact on the founders?

We show the entire model here for easy reference.

Step 1 – Calculate the Conversion Price of Convertible Notes

The first step in modeling the cap table is figuring out the price at which the convertible notes will convert. Since the notes will convert at the lower of the cap price and the discounted price, we need to calculate both prices and pick the lower one.

Cap Price Calculation

The cap price calculation is done by dividing the valuation cap ($4 million) by the shares outstanding prior to the notes conversion.

Cap Price = Valuation Cap / Fully Diluted Shares

Cap Price = $4,000,000 / (9,000,000 + 2,327,879)

Cap Price = $0.3531

Note that the fully diluted shares are not 10 million, as more shares need to be issued to increase the option pool to 15% post-financing. In this case, 1,327,879 additional shares will be issued.

Discounted Price Calculation

To determine the discounted price, we first need to know the price of the Series Seed round, which is the pre-money valuation ($6 million) divided by the shares outstanding prior to the seed round. Note that the shares used in this calculation need to include the shares from the convertible notes conversion, as typically investors will invest on a fully diluted and converted basis. However, the number of conversion shares depends on the Series Seed price, creating a circular reference. This is why iterative calculation needs to be enabled.

Pre-money Share Price = Pre-money Valuation / Pre-money Fully Diluted Shares

Pre-money Share Price = $6,000,000 / 11,639,396 = $0.5155

Now, we can apply the 20% discount to the Pre-money Share Price, giving us $0.4124.

Determine the Conversion Price and Shares

Since the cap price of $0.3531 is lower than the discounted price of $0.4124, we use the cap price as the conversion price.

Remember that the convertible notes carry a 10% interest rate and one year has passed since the angel round. Therefore, we need to account for the interest that has accrued of $10,000 to the principal, making the total investment $110,000.

To find the conversion shares, we divide $110,000 by $0.3531, which gives 311,517 shares.

Step 2 – Determine Series Seed Shares and Ownership

Having calculated the conversion shares, we now know the company’s total share count prior to the seed round. The next step is to determine the number of shares that the seed investor will receive for their $2 million investment.

Since we have already calculated the Pre-money Share Price of $0.5155 in the previous step, we can directly get the number of shares by dividing $2 million by $0.5155 to get 3,879,799 shares, exactly 25% of the company’s new share count of 15,519,194.

Step 3 – Determine Dilution Impact

Now that we have determined how many shares each investor will own after the notes conversion and seed financing, we can evaluate the dilution impact on each shareholder.

We first observe that the financing has the most dilutive impact on the founders, as their ownership falls to 58% from 90%. This is due to dilution from the conversion of the notes, the increase in the option pool, and the seed round.

The convertible notes are similarly diluted, with the ownership stake going from 2.7% to 2.0% after the seed financing. Note that here we assume the notes convert prior to the seed financing, as the seed investor requires a 25% stake. This is typical, but there are instances in which the notes will convert alongside (not prior to) the seed round, meaning the seed investor will be diluted by the conversion and not receive the full 25%.

Additionally, note that the option pool was increased to 20% prior to the round to end with 15%. This method is typical and favors the investor, as the dilution impacts only the founder and not the seed investor. Had the option pool been increased on a post-money basis, the seed investor would also be diluted and not receive the full 25%.

As seen, the cap table can get complicated with different convertible methods and calculations. This is why it is critical for founders to pay close attention to term sheets and how different terms will impact their cap table.