Introduction to Convertible Notes in Startup Financings

Convertible notes have become an integral part of the startup ecosystem, providing liquidity to early-stage investors and flexibility to startups. However, the conversion of these notes can significantly impact the share price in subsequent financings. This article will explore the different scenarios and factors to consider when determining the conversion dynamics and their impact on the share price.

Understanding the Conversion Scenarios

When a convertible note matures or is converted, the conversion event determines the share price for the next round of financing. There are three primary scenarios:

Scenario 1: Full Conversion into Pre-Money Shares

In this scenario, 100% of the convertible note is converted into pre-money shares. This means the note holders will receive shares directly as part of the pre-money valuation.

Scenario 2: Partial Discounted Conversion into Pre-Money, Partial into Post-Money

Here, a portion of the note is converted into pre-money shares based on a discount to the next round's price, while the remaining portion is converted into post-money shares. This scenario requires careful negotiation to balance the interests of both the investors and the founders.

Scenario 3: Full Conversion into Post-Money Shares

In this case, the entire note converts into post-money shares. This means the note holders will receive shares post-closing, which may influence the post-money valuation.

Factors Influencing the Conversion Decision

Deciding on the conversion scenario depends on several key factors:

1. Size of the Discount

The discount rate on the convertible note plays a significant role in determining the conversion scenario. A higher discount can lead to a more favorable outcome for the note holders, while a smaller discount benefits the startup.

2. Amount of Money Invested in the Bridge

The total amount of money invested in the bridge note also impacts the valuation. More substantial investments typically lead to a higher valuation, which can influence the post-money cap and ultimately the share price.

3. Allocation of the Option Pool

The placement of the option pool in either the pre-money or post-money structure can have a profound impact on the share price and equity distribution. Investors and founders must carefully consider this when negotiating the terms.

4. Impact on Founders vs. Investors

The outcomes of each scenario must be analyzed to ensure a fair and balanced approach. The interests of the founders and early investors need to be aligned for long-term success.

Valuation and Calculation of Share Price

Valuation is a critical aspect of the conversion process, and there is no standard approach. Each party in the negotiation must agree on clear definitions to resolve any questions effectively.

Post-Money vs. Pre-Money Valuation

The post-money valuation is the final valuation of the company after the transaction, while the pre-money valuation excludes the cash raised in the transaction. The formula for pre-money valuation is as follows:

[ text{Pre-Money Valuation} text{Post-Money Valuation} - text{Cash on Hand} ]

For example, if a company has a post-money valuation of $10 million and $1 million in cash, the pre-money valuation would be $9 million.

Examples of Real Negotiations

One of the term sheets clearly states:

4 million pre-money Enterprise Value on a fully-diluted basis, including common shares, long-term debt, outstanding warrants, note conversion, issued options, and an available option pool representing 12% of post-money capitalization to be established prior to closing.

This provision, coupled with a detailed spreadsheet, ensures all parties are aligned in understanding the assumptions and calculations.

Detailed Advice for Founders and Investors

Understand the Definitions

Both founders and investors must comprehend the definitions of terms like 'pre-money' and 'post-money' to avoid any misunderstandings. Clear communication and mutual understanding are crucial for a fair agreement.

Pre-Money vs. Post-Money Calculation

The pre-money calculation is essential, especially when considering the impact of note conversion and establishment of an option pool on the share price. Ensuring a clear methodology is in place prevents any conflicts.

Acquire Transparent Detailed Sheets

Founders should request detailed spreadsheets to see the assumptions and inputs used in the valuation models. Understanding the share price calculation provides transparency and trust in the negotiation process.

Conclusion

Converting convertible notes can significantly affect the share price in subsequent financings. Early-stage investors and founders must carefully negotiate the terms to ensure a fair and aligned approach. Understanding the valuation mechanics, particularly pre-money and post-money calculations, is critical for success. Clear communication and detailed sheets help in achieving a balanced outcome for all parties.