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Intuition - Part 2/4: How does a NOTE convert?

Posted by  Rajesh Gopi   on April 09 2022



This is part 2 of a 4 part series.


Read this article that covers the math behind a Post-SAFE.


As before, we will use a very simple cap table set up to understand the intuition for how a Convertible Note converts in a priced round.


Geek Alert: This series of articles are numeric in nature.


Setup: An example cap table

We will use the following cap table scenario.


Cap Table

Founders 3M shares
Options 1M shares
Fully Diluted 4M shares


Convertible Note

Valuation Cap $6M
Discount 20%
Investment $100K


Priced Round

Pre-Money Valuation $8M
PPS $8M / 4M = $2.00



How does a Convertible Note convert? 



Unlike a Post-SAFE, the math behind Convertible Notes are all based on pre-conversion fully diluted shares.



This makes the calculations much simpler than a Post-SAFE.


Similar to a Post-SAFE, a Convertible Note gives the investor better terms between a Cap and a Discount - whichever results in more equity. It is not discount in addition to the cap.


The steps to understand Convertible NOTE conversion are:


a) Determine the number of shares a discount will offer

b) Determine the number of shares a valuation cap will offer

c) Pick the better of the two that gives more ownership to the investor



When does the Valuation Cap on a Convertible NOTE win?

From a high level, this is a 2-step process.


Step 1: Compute the number of shares the Convertible NOTE investor gets if the discount is applied.


Determine the PPS if discount is hit $2.00 * (1 - 20%) = $1.60
Compute the number of shares this PPS gets $100K / $1.60 = 62,500 shares



Step 2: Compute the number of shares the Convertible NOTE investor gets if the cap is applied.


For this, we first determine the ownership interest the Convertible NOTE investor gets on conversion.


Convertible NOTE Ownership at Priced

(before dilution)

$100K / $6M = 1.667%



Next calculate the number of shares that will be issued to the Convertible NOTE investor.


1.667% * 4M = 66,667 shares



That's it.


We can see that the Valuation Cap in this example gives the NOTE investor more shares. So, the NOTE uses the cap instead of the discount.


The effective PPS of the Convertible NOTE can also be quickly calculated.


Effective Convertible NOTE PPS

$100K / 66,667 = $1.50




When does the discount on a Convertible NOTE win?

Now, let's look at another scenario where the deal structure is exactly the same, except that the Convertible NOTE has a 30% discount.


Convertible NOTE

Valuation Cap $6M
Discount 30%
Investment $100K



In this case, the shares received by the Convertible NOTE investor will be:


Determine the PPS if discount is hit $2.00 x (1 - 30%) = $1.40
Compute the number of shares this PPS gets $100K / $1.40 = 71,429 shares



This is more than the shares that the valuation cap would issue to the investor (66,667), so the Discount version gets picked.



What is the impact on dilution by Post-SAFE and Convertible NOTE?

As seen in this article and the previous article, we see that under similar terms, the shares issued to investors and the corresponding equity given out are:


Post-SAFE 67,797 shares
Convertible NOTE 66,667 shares


It's deceptive to assume that using the same valuation cap makes Post-SAFE and Convertible NOTE behave the same. This example shows that Post-SAFE results in higher dilution compared to a NOTE for the same valuation cap.



How can TWO12 help?

In reality, cap tables are complex. Founders typically raise capital using multiple terms and instruments before a priced event. TWO12's built-in modeling engine makes it easy for founders to model and visualize dilution across. Sign up here.



Topics: cap table, Convertible Note, dilution, Convertible NOTE conversion math