Convertible Note Math & Unexpected Dilution

Posted by  Rajesh Gopi   on August 22 2020

 

A convertible note is the most popular instrument used by founders & investors when raising capital. Convertible notes are debt instruments that accrue interest and convert to equity in the next priced round.

 

As founders, do you precisely understand how convertible notes will impact your cap table's dilution and your own personal equity stake? 

 

If not, we are here to help. 

 

A Convertible Note Has 3 Major Components:

 

  • Valuation Cap
  • Discount 
  • Interest

 

Types of Convertible Notes:

There are 3 popular forms of notes. The most favorable to the founders is the ‘pre-money’ note. The other forms are 'percentage ownership’ and ‘dollar invested’. In this article, we’ll assume the ‘pre-money’ type of note.

 

Note Conversion Math:

In plain English, the below formula means that the note holder gets the better of the valuation cap OR the discount.

 

max ( (Note Investment / (1 - Discount)) , ((Note Investment * PreMoney) / Note Cap)) )

 

 

Example Scenario:

Let’s assume that the Founder raised $1M on a note using the following terms:

Cap: $3M

Discount: 30%

Interest: 0% (just to keep the math easy)

 

Further, let’s assume that the founder raised the priced round at:

Pre-Money Valuation: $8M

 

In this example, the $1M Note has the same effect as if $2.67M was invested in the Priced round.

 

max ( ($1M / 0.7), (($1M * $8M) / $3M) ) 

= max ( ($1.43M), ($2.67M))

= $2.67M

 

Impact to Dilution:

Most founders are surprised (borderline shocked) after Note converts. 

 

In this example, the Founder got diluted from 100% to 75%.

 

At TWO12 we take care of this complex math for you: 

 

Screen Shot 2020-08-22 at 12.32.22 PM

 

It gets worse for the founder after a post-money option pool is created and Series-A money comes in.

 

For example, if the Series-A investor requires that the company create a 10% post-money option pool for a $2M Series-A investment, the founder gets diluted to 53%.

 

We want founders to leverage their most valuable resource, their company's equity, with foresight and precision. TWO12's cap table platform provides all the features out of the box to help founders model out capital raises and make informed decisions when accepting investment. 


Sign up at https://sigma.two12.co/sign-up.

 

Topics: Knowledge, cap table, startup, Convertible Note