In the past we’ve talked about structuring and maintaining capitalization tables and thresholds and mechanics involved in converting convertible notes into equity. It makes sense that convertible notes would impact a venture’s cap table; after all, they have the ability to convert into stock of the venture (at least in certain circumstances). But since the class or series of stock and the number of shares into which they convert can be difficult or impossible to determine until they actually convert, which often relies on outside events, it can be a challenge to get convertible debt to play well with the cap table. Today we will examine different ways that convertible notes can convert and impact a company’s capitalization, particularly when determining a price per share in a new equity round.
Price Per Share of the New Round
Calculating the price per share for a new equity round is generally straightforward: simply take the pre-money value of the company and divide that by the number of shares of common stock outstanding on a fully diluted basis. Recall that the fully diluted number includes all shares of common stock that are outstanding or could be outstanding, meaning all preferred stock being treated as if converted to common and including the entire option pool (even shares that are unvested or shares that are reserved but not allocated to service providers).
For example, if a company with a pre-money valuation of $10 million has (i) 500,000 shares of common stock outstanding, (ii) 200,000 shares of Series A Preferred outstanding (converting at a 1:1 ratio), and (iii) an option pool of 125,000 shares (roughly 15%), then the fully diluted number of shares is 825,000 and the price per share of the next equity round would be $10M/825,000 or $12.1212 per share.
If the new investor plans to invest $2.5M, at first glance this would appear to give the company a $12.5 post-money valuation, and the new investor would account for 20% of the company, with the existing stockholder base and option pool holding the other 80%. The new investor would buy 206,250 shares at $12.1212 per share in making her $2.5M investment, and 206,250/(825,000+206,250) comes out to 20%, as expected.
Impact of Convertible Debt
This simple situation is more complicated if a company has convertible debt on its books. Suppose the venture has $1M in outstanding convertible notes that will according to the terms of the notes convert at a 20% discount in connection with this new equity round. The notes need to be accounted for in setting the price per share. So while the price per share to be paid by the new investor depends on knowing how many shares the debt converts into, knowing how many shares the debt converts into depends on knowing how many shares the new investor would get.
This can be addressed in several different ways, with different results. For instance:
- Viewed from a post-close perspective, the new investor could have his full 20%, as he expected, with the existing stockholders being diluted below their expected 80% to accommodate conversion of the notes; this is the most investor-friendly result.
- Conversely, the existing stockholders could have their full 80% after the transaction, with the new investor having less than his anticipated 20% to accommodate conversion of the notes; this is the most existing-stockholder-friendly result.
- Finally, there are middle ground approaches where both the existing stockholders and new investors suffer some dilution to accommodate the conversion of the notes.
The most investor-friendly method ((1) above) locks in the new investor’s expected percentage ownership and works backwards, basing all calculations off of this fixed number. Some mathematical magic reveals that the price per share in this situation would be $8.1818 and the new investor would purchase 244,445 shares to make his $2M investment. The notes would convert at $6.5454 (the price per share less the 20% discount), resulting in 152,778 shares.
At the end of the day, under this scenario, the fully diluted number of shares is 1,222,223, with the following results:
|New investor @ $2.5M:||244,445/1,222,223=20.00%|
|Existing stockholders and option pool:||825,000/1,22,223=67.50%|
The most existing-stockholder-friendly method ((2) above) is essentially identical to the method above, except that it locks in the existing stockholders’ expected percentage (in this case, at 80%) and works backwards from that result. In practice, investors are unwilling to use this method for calculating the price per share of a new round because it has, by far, the least favorable result for the new money.
Two “middle of the road” approaches ((3) above) are also available, whereby both the new investor and the existing stockholders absorb some of the dilution required due to the conversion of the notes.
One way is to look at all of the dollars invested in the company (including the outstanding principal and interest on the notes) to calculate the post-money value of the company. In our example, this would give a post-money valuation of $13.5M, based on the $10M agreed to as the pre-money value, the $2.5M from the new investor, and the $1M outstanding under the notes.
In our example, this works out to a price per share for the new investor of $11.8182, meaning the new investor would purchase 211,538 shares to make his $2.5M investment. The notes would convert at $9.4546 per share, taking into account the 20% discount. This means the noteholders would receive 105,769 shares. Under this scenario, the fully diluted number of shares is 1,142,307, with the following results:
|New investor @ $2.5M:||211,538/1,142,307=18.52%|
|Existing stockholders and option pool:||825,000/1,142,307=72.22%|
The second of the middle approaches is the simplest in terms of calculating the new price per share, and is likely the most common method (although falling out of favor with investors as it dilutes them more than looking at the total number of dollars invested). This approach simply uses the agreed pre-money value of the venture as the main variable in calculating the price per share, as if the notes didn’t even exist. So here we would have $10M divided by the fully diluted share number of 825,000, resulting in $12.1212 per share. This becomes $9.6970 when taking into account the 20% discount on the notes. The new investor would purchase 206,250 shares to make her $2.5M investment, while the $1M in notes would convert into 103,125 shares at the discounted price. Under this second middle approach, the fully diluted number of shares is 1,134,375, breaking down as follows:
|New investor @ $2.5M:||206,250/1,134,375=18.18%|
|Existing stockholders and option pool:||825,000/1,134,375=72.73%|
As you can see, the presence of outstanding convertible notes can complicate the determination of price per share in a new equity round, despite the mechanics of conversion contained in the notes themselves (which could be very simple and straightforward). The approach to share price should be negotiated with a new investor very early on in the process, as the investor could consider the adoption of one approach over another to be a breach of the terms sheet (which itself might be silent as top the method of calculations to be used). Also important to note is that any approach to the conversion of the notes that is not within their mandatory conversion provisions means a negotiation with the noteholders as well.