You have raised seed via SAFE/Convertible notes and you are now converting them to equity in your first venture round. The convertible agreement is standard. There is a discount rate, a valuation cap and maybe a clause for convertible overhang (if you don’t have the clause or don’t know what this is, read more details here). It seems simple enough, isn’t it?
It turns out it might not be as straightforward as you think. There are at least three ways you can play the conversion game and each results in a different dilution outcome. As a founder, knowing the difference can guide you in negotiations with new investors and avoid excessive dilution to preserve founder control. Here, I am going to walk you through the two most common approaches when it comes to conversion. A quick note on ESOP. Often, investors will request a 10% of ESOP post investment. To minimize your dilution, it should ideally come last otherwise you are diluting yourself only. However, this might be the compromise you need to give in the negotiation and you end up doing it pre-raise. Here we assume you share the dilution with the investors.
The two approaches are the fixed pre-money approach and the fixed post-money approach. Assume we have a seed stage company that recently secured Series A investment. The company has raised $1 million convertible notes before with the following attributes:
The new investors have agreed to invest $2,000,000 on a $10,000,000 pre-money valuation. To find out how many new shares the company needs to issue to the new investors and the convertible note holders, we will need to find out the Series A share price and the conversion price respectively. Now let’s do the math.
Fixed Pre-money Approach
Under the fixed pre-money approach, the convertible note is NOT included in the pre-money valuation. The “effective” pre-money is the same as the stated pre-money. The post-money is calulated as pre-money valuation plus investment plus cap-adjusted convertible note value. In this case, Series A Price can be simply calculated as $10 million divided by the 1 million total shares outstanding. Once we have a price for Series A, we can subsequently calculate convertible price with discount and compare it with convertible price with valuation cap. The lower of these two will be your conversion price.
The resulting cap table is include here factoring a 10% ESOP which most investors require.
Fixed Post-money Approach (or percentage ownership approach)
Under the fixed post-money approach, the post-money valuation is fixed at pre-money plus investment. This means that the convertible note IS now included in the pre-money valuation. What it means that the “effective” pre-money will be lower as the convertible note needs to be deducted from the number. The pre-money valuation that is used to calculate Series A price is now $8.57 million instead of $10 million. This leads to a lower Series A price and subsequently lower conversion price. Lower prices mean high dilution and hence more shares will be issued.
The resulting cap table under the fixed post-money approach looks as below. The founders will be diluted further using this method with convertible holders and Series A investor receiving a bigger size of the pie.
As you can see here, with the headline terms fixed, there are different ways you can calculate share prices which result in different dilution dynamics. As a founder, knowing how the math works can aid your negotiation when it comes to which compromises to make.