Conversion Issues with Convertible Notes and Convertible Equity
Convertible notes and convertible equity (like SAFEs) are generally simpler, more cost-effective instruments for a startup’s seed financing than convertible preferred stock. However, there is some unexpected complexity to these instruments when they convert in the next financing round. This complexity stems from the fact that there are several ways to calculate the conversion of these instruments. The purpose of this post is to highlight the different methods that can be used to calculate how many shares convertible note or equity holders will receive at the next round.
The pro forma
If your seed round was comprised of convertible notes or convertible equity, then it is imperative that you, your convertible note or equity investors from your seed round, and the VC leading your Series A agree to a pro forma as early as possible in the Series A negotiations.
Pro Forma: A pro forma model shows in detail how the conversion of the convertible note or convertible equity instruments will be calculated at the next round of financing. It will break down the share price and the amount of shares the convertible instrument investors will receive at the next round.
It is important for everyone to agree on a Pro Forma model on how the notes or equity will convert because there is not a standard way to calculate the conversion (there are a few), and the convertible note or equity instruments may not provide clear instructions on how to calculate the conversion.
Calculation Issues At Conversion
When it comes to calculating the conversion of these instruments, the relative ownership percentages of the convertible note or equity holders, the founders, and the Series A VC’s can vary substantially based on the treatment of the following factors in the conversion calculation: 1) the conversion shares; and 2) the option pool.
The Conversion Shares are the Series A shares given to the convertible equity or note holders at the time of conversion. These shares can be included in the pre-money capitalization for purposes of calculating the price of the Series A preferred stock that the new VC investor purchases. Under this method, only the existing stockholders (such as the founders) are diluted by the conversion. Alternatively, the shares related to the conversion can be added on top of the new Series A shares from new money in the post-money capitalization. This method results in the new Series A investors (as well as all the other existing shareholders) being diluted by the conversion.
The Option Pool is part of the equity incentive plan that VC’s require of every startup. It is an allocation of shares in the company, usually 20%, to be given to key personnel. VC’s typically require companies to include the option pool shares in the pre-money capitalization for purposes of calculating the price of the Series A preferred stock. If the option pool is included in the pre-money valuation, it will cause additional dilution for the founders. Alternatively, the company and the VC investor sometimes agree to a lower pre-money valuation for the Series A round, but with an understanding that the option pool will be adopted after the round is completed. If the option pool is adopted after the Series A financing, then all of the company’s stockholders (the founders, the convertible note or equity holders, and the new Series A investors) are diluted.
It is pretty clear to see that the founders and Series A VC’s are going to be at odds on how to calculate the conversion of the convertible notes or equity. When it comes down to it, calculating the conversion shares and the option pool into the pre-money allocation is the most common and most fair to the VC’s, especially if you have a lot of convertible notes or equity outstanding. Be warned, if you do not want the conversion shares and option pool to be calculated in this manner, the VC’s will probably lower your pre-money valuation so they can get the percentage of ownership in the company they want.