Corporate Finance & Securities

Founder Math: Comparing Convertible Notes & Priced Equity

Convertible NotesEarlier this week, I presented at a CLE on early-stage financing. In my preparation for that, I was reviewing recent articles people had written about convertible notes, and I came across Fred Wilson’s post explaining why he still doesn’t think convertible debt is a good deal for founders. (I agree with him as I’ve detailed in a prior post.) One of the things Fred points out is that founders should always be comparing how the share ownership would pencil out given different potential outcomes. Again, I agree. And to make it easier for founders, we’ve put together the spreadsheet below that will automatically calculate ownership percentages based on a few variables.

You can edit the six variables in red at the top, and the rest of the numbers will show you how the ownership numbers and percentages would shake out if you raised your initial round as a capped convertible note, an uncapped convertible note, or a priced equity round.

A few caveats:

  • There are all sorts of variations that we could have added. Before you take hundreds of thousands of dollars from someone, it’d be worthwhile to make sure that your financial modeling is accurately capturing the specific terms of your deal.
  • With a traditional convertible note, there’s generally an interest calculation, and the interest you owe will be added to the principal of the note. The investor will get an amount of shares based on principal and interest. Newer alternatives to convertible notes—like the SAFE docs and some of the KISS docs—don’t have interest. The notes calculated here are more like the KISS and SAFE docs in that respect. To provide calculation for traditional convertible notes you’d need to add in an interest percentage and a way of calculating how long the debt was outstanding. Not too tough to do, but it’d clutter things up a bit so we left it out of this version.
  • Both of the convertible notes modeled here have discounts—not all convertible notes have discounts.
  • We built in a broad-based weighted anti-dilution provision into the calculations for the equity seed investor. In the event of a down round, this means the equity seed investor will receive rights to additional shares, which further dilutes founders (but you can see that if the series A is at a lower valuation, founders are better off if the seed deal was equity rather than debt).

Notes on the variables:

  • The employee pool is a reserved number of shares to issue to key employees in the future. Here, it’s calculated based on the percentage of shares set aside before issuing equity to investors (the employee pool will be diluted by the shares issued to investors).
  • Seed investment is the total amount of money raised from your seed investors.
  • Note cap/Seed pre-money valuation is the agreed upon highest possible valuation used to calculate the note holders’ per share price. The cap on price sets a floor on the ownership percentage an investor will have upon conversion. This variable is also the pre-money valuation used for the calculation for priced round seed investors.
  • Note discount is the discount on the share price a Series A investor pays. In the variable section, put the discount off of the price per share. Sometimes you see the discount listed as the percentage of the price that will be paid (so a 20% discount off may be written as “the note holder will pay 80% of what the Series A investor pays”).
  • Series A Ownership % is the percentage of shares the investor will own after the transaction. Depending on how you word the terms with the Series A investors, this % may or may not be immediately diluted by converting note holders. The model we’ve provided here assumes that the Series A investors will be diluted by the conversion, but founders should not assume their Series A investors will necessarily be operating under this assumption.
  • Series A Investment is the total amount of money series A investors are investing into the company.
  • For calculating how many shares an investor will receive, you need to know the amount of money they’re putting in and either their ownership percentage after the transaction or the pre-money valuation—so you could build this same table with different inputs.

Explaining the far right columns:

  • Notes with a discount and a cap will convert at whichever share price calculation is better for the investor—that is, whichever will provide the investor with the most shares. The table shows the price under the discount and the price under the cap, and then the corresponding share price is whichever of the two is lower.
  • Preferred shareholders, as mentioned above, often have anti-dilution protection. The “AD” column uses broad based weighted anti-dilution to calculate how a typical anti-dilution measure would adjust the seed investors’ shares in the event of a down round. If the “AD” share price is lower than what the seed investor originally paid, the new “AD” price will be used to calculate the number of shares the seed investor has (or would have upon conversion of preferred stock to common stock).

*I’m trying to remove the requirement that you have to login to a Microsoft OneDrive account in order to be able to use this, but I haven’t gotten there yet. If you don’t want to log in, you can download a copy of the excel file here: Founder Math 03.17.17

Photo: Behdad Esfahbad | Flickr

        


Kyle Hulten

When I'm not in the office I enjoy cooking, gardening, and watching my toddler son explore his little universe.


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