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​example​After adding their first employee, Pext, Inc. decides to raise a small amount of external capital, $400K, in order to pay some contract developers for the MVP of the product and to cover some marketing expenses to do early customer acquisition testing. Because they are raising less than $500K, and want to minimize the legal costs, they raise capital in the form of a convertible note. The note has the following key terms:

  • valuation cap of $3M
  • discount of 20%
  • qualified financing for mandatory conversion must be a preferred stock offering of at least $1M
  • interest at 5%

There are no shares sold during a convertible note offering, since it is debt, and therefore there is no change to the cap table.

A year later the company has made great progress and decides to raise $2M. They do this in the form of a Series Seed Preferred Stock financing.

Because a preferred stock round will be a priced round, the company will have to negotiate a pre-money valuation for the company (or the equivalent). The founders and the existing note holders ideally don’t want to give up more than 20% of the company in this round in return for the new infusion of $2M. A quick calculation suggests that the pre-money valuation would have to be $8M for that to be the case:

This financing will trigger the mandatory conversion of the convertible notes from the prior financing because it meets all of the criteria. That conversion of debt to equity will impact the cap table as well.

As we discussed at length above, the option pool will need to be addressed as well as part of this financing. Let’s start by taking another look at our summary cap table Figure 3S, where we have a single line item for Founders and one for Employees.

FIGURE 3S: SUMMARY VERSION OF FIG 3

Shares or OptionsIssued and OutstandingFully Diluted
Founders10,000,00096.67%86.96%
Employees345,0003.33%3.00%
Issued and Outstanding10,345,000100.00%
Option Pool Available1,155,00010.04%
Total Fully Diluted11,500,000100.00%

The preferred stock investors feel that the $8M pre-money is at the high end of what they are comfortable with, so they insist that the terms be written such that they own 20% of the company on a fully diluted basis post investment and that the option pool be topped up to 15% of the final cap table post investment.

There are a lot of unknowns here, so we’ll take it a step at a time. We can think about this as three separate transactions:

  1. The convertible note holders convert at the valuation cap. (We will check later if it would have been beneficial to convert at the discount.) This will dilute the founders and employees and reduce the relative size of the option pool.
  2. The option pool will get topped up.
  3. The preferred investors will come in.

Effects of Note Conversion on Dilution

While note conversion terms can be written in slightly different ways, for our purposes, we will use a simple example where the stock price using the valuation cap conversion option was specified to be calculated as follows: Valuation cap divided by the issued and outstanding securities immediately prior to the sale of the preferred. The valuation cap was $3M. The number of issued and outstanding securities was 10,345,000 per the cap table in Figure 3. The price per share is therefore $3M/10,345,000 or $0.28999517.

The 5% interest on the $400K in notes would have generated an additional $20K in the intervening year, so the convertible note investors will be converting $420K into shares at $0.28999517. Running the math, the convertible note holders will get $420K/$0.28999517 = 1,448,299 shares. So the conversion of the notes before any other actions would have the cap table looking like this:

Figure 4: Cap Table Accounting for the Conversion of the Convertible Notes

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