More and more startups are getting investments through convertible debt instruments. Here’s everything you need to know about convertible debt, how it works, and how it affects your cap table.
The use of convertible debt and other convertible instruments (SAFE & KISS Notes) has increased in popularity among early stage companies. However, many founders do not fully understand how these equity derivatives affect their cap table, especially with regard to the mechanics of conversion. We’re going to break it down so you can fully understand your own cap table.
Raising Capital with Debt and Equity
Companies have two mechanisms through which they can raise capital: debt and equity. Debt has the advantage of being cheaper than equity in most situations. The downside is having to pay it back in full, with interest upon maturity.
A startup will often see several years of operations before achieving positive cash flows, making debt an impractical and risky means of financing the company. For this reason, true debt is often not available for a startup.
This is why startups have traditionally funded their operations through the sale of equity. With ownership in the company, the investors are also incentivized to help the company succeed. They will only receive a return on their investment upon a successful exit of the company.
The difficulty of selling equity as an early stage startup is that founders and investors must agree on the value of the company. In the very early stages of a startup, coming to an exact valuation can be very difficult; an early stage startup often has no revenue, little to no customers, and very few other indicators of value. If both sides cannot come to an agreement on the company’s valuation, it will kill the deal.
To solve this problem, convertible debt was introduced, essentially providing a way to kick the problem of valuing the company down the road. Money is invested today, and the valuation happens later.
Convertible debt (also known as venture debt or bridge notes) has a date of issuance, an interest rate, and a maturity date. Upon maturity, they can be repaid with cash, just like with any other form of debt. What makes convertible notes unique is that they are typically repaid with equity.
The number of shares given to the note holder as repayment is largely determined by four factors:
- The outstanding balance on the note
- The value of the company upon repayment
- The number of shares that are currently issued and outstanding
- Other terms on the note such as conversion caps and conversion discounts
A conversion cap sets an artificial max valuation of the company at which the debt will convert into equity. The conversion cap is expressed in a dollar amount, e.g., $1,500,000. However, if the company’s actual valuation at the time of financing is lower than the conversion cap, the debt converts at the company’s actual valuation.
A conversion discount specifies a discount rate that is applied to the company’s valuation for purposes of calculating a conversion price. This is typically expressed as a percentage, e.g. 20%. For example, if the company’s valuation is $2,000,000 and the discount is 20%, then the debt will convert at a valuation of $1,600,000.
The principle behind these terms is that the debtholders invested earlier in the life of the company, taking on greater risk, and therefore should be able to buy in at a lower share price than the next investors.
Convertible notes don’t have to specify a conversion cap or a conversion discount, but they usually do. It’s also not uncommon for them to specify both. In any case, the debt will convert at the valuation that is most economically advantageous for the note holder.
The Mechanics of Conversion
Below we have a simple capitalization table (or cap table) with three founders who each own 300,000 shares. An additional 100,000 shares have been set aside in an option pool for future hires, for a total of 1 million shares.
The company also has two convertible notes with conversion caps (but no conversion discounts):
The company now seeks to raise its Seed Round. The founders are seeking $500,000 of additional capital at a pre-money valuation of $3,000,000. They will also convert the debt into the seed round as part of the transaction.
So how many shares does everyone get? The first step to answering this questions is finding the share price paid by each investor.
This is easy enough to do. The new investors agree that the company is worth $3,000,000. Looking at the fully-diluted cap table, we see that there are 1 million shares outstanding. We divide the pre-money valuation by the fully-diluted number of shares to find the price per share of the Seed Round:
The new investors are investing $500,000, so they will receive 166,667 shares of preferred stock:
The debtholders, however, do not pay $3 per a share for their preferred stock. Both debtholders negotiated for a conversion cap when they invested – Anderson Capital at a $1,000,000 cap and Schuller Ventures at a $1,500,000 cap. Therefore, Anderson Capital will convert to equity at $1 per a share:
Schuller Ventures will convert over at $1.50 a share:
At these share prices, Anderson Capital will receive 250,000 shares of Series Seed stock and Schuller Ventures will receive 166,667 shares. The company’s cap table now has a total of 1,583,334 shares:
The founders have been diluted down from 30% each to 18.95% each. Also take note that although Anderson Capital and Schuller Ventures each invested the same amount of money, Anderson Capital has more shares. This is because they negotiated for a lower conversion cap than Schuller Ventures.
Similarly, Schuller Ventures has the same number of shares as the New Investor, although they only invested half as much money. Again, this is because of the $1,500,000 conversion cap.
Conversion Cap vs. Conversion Discount
In the example above, both debtholders held notes with conversion caps. The math with a conversion discount is not very different. If the terms of a convertible note specify a 20% discount, and the price per share paid by the new investors is $3, then the note holder would convert to equity at a share price of $2.40. A convertible note with an outstanding balance of $250,000 would convert into 104,167 shares.
The Fully Diluted Cap Table
Smart investors always do their math in terms of the “fully diluted” cap table, and smart founders should too! Fully diluted simply means counting the shares that have been set aside by the board for issuance (generally in the form of options) but have not yet been issued.
Let’s look again at the beginning cap table from the previous example.
The company has actually only issued 900,000 shares, but it is proper to include the 100,000 shares set aside in the equity plan for issuance when doing the math. These shares are treated as issued because there is a real intent to issue them.
Investors generally force founders to set aside an option pool before investing in them. They don’t like investing in a company only to get diluted the later upon the hiring of a CFO, CTO, or other officer.
Understanding this concept, some founders become overzealous and want to include ALL authorized shares in the fully-diluted cap table. This is incorrect for three reasons.
First, just because shares are authorized does not mean there is real intent to issue them. The authorized share count simply represents the number of shares authorized to be issued according to the company’s certificate of incorporation.Think of it this way – just because you can issue them, it doesn’t mean you willissue them.
Second, if or when you do decide to issue more shares in the future, your new investors will get a say in things. They are willing to be diluted under the right circumstances (the raising of a future round). Options, however, are generally granted out of the option pool without any input from the investors, so they just want to know what the dilution looks like up front.
Lastly, the authorized number for common is large enough to facilitate the conversion of all preferred securities into common stock. If all the authorized shares were considered in the fully diluted cap table, the preferred shares would be double counted.
Pre-Money vs. Post-Money Valuation
Never has such a simple concept tripped up so many people. The pre-money valuation is simply the value of the company before any new money is invested.
In the example used above, the pre-money valuation was $3,000,000. This meant that each of the company’s existing 1 million shares was worth $3. After the new investors added $500,000 to the company’s books, the company instantly increases in value by $500,000. So $3,500,000 is the post-money valuation.
The post-money valuation is simply the value of the company after the new investment round. Investing $500,000 at $3,000,000 pre is the same thing as investing $500,000 at a $3,500,000 post.
When calculating the price per share of the new round given the fully diluted number of shares, one should use the pre-money and not the post-money valuation.
Problems with Convertible Debt
Although convertible debt solves the problem of valuing the company at the time of initial investment, it still has one big drawback – it is still debt!
A convertible note will accrue interest (usually between 5 and 10 percent). This is disadvantageous to the founders. For example, if an investor has a note for $100,000 at a 5% interest, they will receive $105,000 worth of equity if there is a one year maturity.
However, they will often get to invest (because of a conversion discount or conversion cap) at a valuation that represents the company’s value at the start of the loan, and not the end!
Additionally, because a convertible note is debt, companies are legally obligated to repay (unlike with equity). This is an additional liability hanging around the neck of an often already fragile startup.
The above problems have led many companies and investors to start using convertible instruments that are not debt, but have many similarities.
The SAFE (Simple Agreement for Future Equity) was introduced by Y-Combinator back in 2009. It is NOT debt. There is no interest and no maturity date. The company is under no legal obligation to repay the investors.
In layman’s terms, it is a contract in which an investor gives money to the company today in exchange for equity at a future date. SAFE’s can have conversion caps and conversion discounts, and for modeling purposes, they act just as convertible debt does – all the math is the same at the time of conversion.
A SAFE might also be compared to a warrant or option – it is a promise for future equity. However, unlike an option or warrant where capital is invested at the time of conversion, with a SAFE, the capital is invested upfront.
The SAFE is a standardized document that is open source and free for anyone to use. Y-Combinator’s stated goal was to provide a document that was fair and neutral to both the investor and company. There are a few standard templates of the SAFE to help decrease legal fees and reduce negotiation times.
The KISS (Keep It Simple Security) was released by 500 Startups in 2014, which is another set of open source docs to help investors and companies negotiate convertible debt-like investments.
There are two standard versions of the KISS, one is a debt version with interest and maturity, and the other is a non-debt version without. Like the SAFE, the stated aim of the KISS is to reduce legal fees and accelerate the negotiation process.
Modeling the conversion process of a standard KISS document is similar to convertible debt. However, there are some versions of the KISS documents, such as the KISS-A, where the mechanics of conversion are quite different.
A KISS-A generally states that the investor will own a certain percentage of the post-money cap table. The math isn’t much more complicated, but we won’t be covering it here
When to Convert into Equity?
There is no “correct” time to trigger a conversion. When to convert will often depend on the company’s growth and when the first round is raised. Sometimes it may come down to the terms specified in the legal documents.
Realizing that the timing is unique to each situation, there is one rule that founders and investors should both know (but most don’t) — converting debt before the next round is raised will dilute the founders more than if the debt had been converted as part of the next round.
Let’s go back to the original example and do the conversion in TWO steps instead of one. First, let us convert the notes (at $1 a share for Anderson Capital and $1.50 a share for Schuller Ventures). The cap table is now as follows:
The new investor then invests the same $500,000 at the same $3,000,000 pre. Again, the price per share is calculated by dividing the $3,000,000 dollar valuation by the number of fully-diluted shares:
Now the price per a share the new investor pays is $2.12 instead of $3! Because the debt converted first, there are now more shares on the cap table, which means a larger denominator, which causes the price to be lower. And with a lower share price, the new investor receives more shares:
This leads to even greater dilution to the founders than in the original scenario.
In the previous conversion scenario the founders each owned 18.95% of the company, but by converting in two rounds instead of one, the founders are diluted down to 18.15%. The difference may seem like minutia, but compare the difference for the new investor. Before, the new investor had 10.53% of the cap table – now it’s 14.28%!
There is no fundamental change in the valuation of the company (it’s still $500,000 at a $3,000,000 pre), but switching up how things convert drastically affects the cap table.
In total, including the option pool, the founders give up an additional 2.67% of the cap table. That is enough equity for two or three key hires.
This is not just a lesson for founders to learn. I have seen debtholders specifically ask the company to convert notes into stock, even though the company is no where near their next financing round. Because they did not understand this principle, the debtholders ended up with a smaller percentage than they otherwise would have.
The Importance of the Cap Table
There are a million things for a founder to do when running a company, and sometimes it’s easy to let things fall by the wayside. But you do not want to underestimate the importance of your cap table.
A founder must understand the equity structure of his or her company. Otherwise, it is far too easy to make bad equity decisions when raising money. At all times, there should be an accurate record of who holds how much and the terms of each class of security.
Investors are not out to take advantage of founders, but they have economic incentives that motivate them. Founders are at a disadvantage in negotiations if they are not aware of these incentives and the tools investors use to get better returns. Plus, investors are impressed by cap table-savvy founders, so taking the time to understand this stuff only helps you.
The concepts outlined in this article are not complex, and the math is no more difficult than what a 5th grader could handle. Yet many founders still don’t understand it, largely because nobody has ever laid it out in simple terms.
Hopefully this post has helped, but we could have covered plenty more. A few additional resources are listed below to help you research the topic more thoroughly.
Lastly, it goes without saying, but I’ll say it anyways. Whenever signing legal paperwork, especially around decisions as important as fundraising, you should seek counsel from a trusted attorney. A $500 fee now can literally save you millions down the road.