Dilution and Conversion

7 minutes


Updated September 19, 2022
Angel Investing

You’re reading an excerpt of Angel Investing: Start to Finish, a book by Joe Wallin and Pete Baltaxe. It is the most comprehensive practical and legal guide available, written to help investors and entrepreneurs avoid making expensive mistakes. Purchase the book to support the authors and the ad-free Holloway reading experience. You get instant digital access, commentary and future updates, and a high-quality PDF download.

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

exampleAfter 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.

Unlock expert knowledge.
Learn in depth. Get instant, lifetime access to the entire book. Plus online resources and future updates.


Shares or OptionsIssued and OutstandingFully Diluted
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

Shares or OptionsIssued and OutstandingFully Diluted
Convertible Note Investors1,448,29912.28%11.19%
Issued and Outstanding11,793,299100.00%
Option Pool Available1,155,0008.92%
Total Fully Diluted12,948,299100.00%

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

Shares or OptionsIssued and OutstandingFully Diluted
Convertible Note Investors1,448,29912.28%9.98%
Issued and Outstanding11,793,299100.00%
Option Pool Available2,721,53118.75%
Total Fully Diluted14,514,830100.00%

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

Shares or OptionsIssued and OutstandingFully Diluted
Convertible Note Investors1,448,2999.39%7.98%
Preferred Stock Investors3,628,70823.5320.00%
Issued and Outstanding15,422,007100.00%
Option Pool Available2,721,53115.00%
Total Fully Diluted18,143,538100.00%

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.

Dilution From the Departure of a Founder

After two years with the company, Joe, one of the founders, has become restless and decides to leave the company to become a crabapple farmer in New Zealand. Because the company was set up by competent attorneys, the founders were on four year vesting schedules. Joe is exactly halfway through his vesting schedule, so upon his departure, the company will buy back 50% of his shares, or 1,700,000 shares. These shares were purchased by Joe as part of the company setup for a fraction of a penny per share, let’s say $0.001 per share. Joe would have originally bought his shares two years ago for $3,400, and will sell half back for $1,700. But aren’t Joe’s 1,700,000 shares, which represent 9.37% of the company—which a year ago had a post-money valuation of $10,000,000—worth close to a million dollars? They might be, but the terms of stock purchase agreement and the vesting schedules therein would have stipulated that upon departure the company has the right to buy back any unvested shares at the issuing price, in this case $0.001 per share. This is a bummer for Joe, but he is, after all, walking away with the 50% of his stock ownership which he had vested. When the stock is repurchased by the company it is typically retired or returned to the treasury, so for all practical purposes, it is removed from the cap table.

The good news for the other stock owners is that by removing a large chunk of the issued and outstanding stock from the cap table, their ownership stakes go up.

Figure 7A: Change in Ownership Stake After a Founder Departure

You’re reading a preview of an online book. Buy it now for lifetime access to expert knowledge, including future updates.
If you found this post worthwhile, please share!