Dilution and Conversion

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So far, we’ve walked through the story of a company that goes straight to raising a priced round, and explored a couple of scenarios to demonstrate some key concepts and mechanics. In this section, we’re going to pick up the story of the same company back after they added their first employee. Instead of going straight to a priced round, the company first raises a convertible note, then a preferred stock round. How will this series of events affect the cap table and investor ownership?

Let’s find out!

Convertible Note to Priced Round

• 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 valuation for the company. 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

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

Option Pool Top-Up

Now the option pool has to get topped up such that it will be 15% of the fully diluted shares after the dilutive effect of the preferred stock sale. Because the preferred stock sale will cause a 20% dilution (selling 20% of the company) across the board, the option pool must be 18.75% prior to being diluted by the preferred stock:

Figure 5: Cap Table Accounting for the Increase in the Option Pool

The stock option pool must be increased from 1,155,000 to 2,721,531 in order for each to reach 18.75% of the total fully diluted shares. From Figure 5 above, it is clear that all equity and option owners have shared the burden of the increase in the stock option pool when calculated on a fully diluted basis.

Sale of Preferred Stock

The terms of the stock sale stipulated that the preferred stock investors would own 20% of the company on a fully diluted basis, and that at that time the option pool would represent 15% of the company on a fully diluted basis. Those conditions result in the cap table represented in Figure 7 below.

Figure 6: Cap Table After the Preferred Stock Sales

You can see that our 18.75% option pool in Figure 5 has been diluted by the new investment as well, and is now at the target 15%.

So what is the price per share that the preferred stock investors paid? They spent $2M for 3,628,708 shares, or $0.55116 per share.

Checking the Convertible Note Conversion

We started working through the impact of the preferred stock investment on the cap table by assuming that the note holders would be better off with the valuation cap conversion than the discount conversion, but let’s check.

If the noteholders had converted their $420K at the 20% discount, they would be paying $0.55116 multiplied by $0.80 per share, or $0.44093 per share. And $420K divided by $0.44093 is 952,532 shares.

Converting at the valuation cap generated 1,448,299 shares, so that was clearly the more advantageous conversion option.