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This blog is written by Austin Conner and covers a mix of business topics that interest me.

I am a contract CFO/financial consultant and I work with with a number of business models and industries: recurring revenue (SaaS - B2B and B2C, ecommerce subscription, membership, consumer products), paid apps (edtech, fitness), internet advertising and traditional ecommerce/retail.


Cap Table Part II - Adding a Convertible Note

In the previous blog post titled "Brightwheel Case Study - Cap Table Math," we looked at the capitalization assuming 100% equity financing; however, it is quite common for entrepreneurs to use convertible notes in early financing rounds because it provides the advantage of postponing discussions about valuation.  

We will keep all our assumptions in the previous post and add a convertible note into the mix.  In early 2014, we will assume Brightwheel issued a $250K convertible note to angel investors with the following terms: 

  • Discount Rate: 20%. This represents the valuation discount holders of the note receive to the investors in next financing round. Think of it as compensation to your investors for taking on the risk of investing in your company at such an early stage.
  • Valuation Cap: $3 million. This feature caps the amount at which the notes will convert during the next financing round and provides additional protection for the holder.  
  • Important: You can have a convertible note with either a discount rate or valuation cap or both. If you have both, then during the subsequent financing round, you use what gives the investor the lowest price per share.
  • Interest rate: 7%, interest accrues to the principal increasing the number of shares on conversion. In other words, there is no cash interest paid.
  • Maturity date: we won't include one here because most, if not all, convertible note holders invest to see the upside on their conversion to equity and not on the accrued interest/return of principal.

Here is a summary of the convertible note round in early 2014 (as you can see, we don't need to worry about valuation as those values are left blank): 

Now let's add the convertible note to the mid 2015 seed round. First, some calculations: 

  • The convertible note principal amount is $268,986.  $250,000 plus accrued interest of $18,986
  • To calculate the conversion, we need to figure out which is lower - the share price at 20% discount or at $3 million value cap. The share price prior to funding round is $4.25, calculated by dividing the $6.0 million pre-money valuation by the number of shares prior to the seed round of 1,412,000
  • The share price using the valuation cap is lower:

Valuation Cap - $3 million:

$3,000,000 / 1,412,000 = $2.12

20% Discount:

(1 - 20%) x $4.25 = $3.40

  • To find the number of shares for the angel investors, we take the $268,986 principal and divide it by $2.12, which equals 126,603. This worked out well for the angels as their effective discount was about 50% with the cap. The angel's equity is worth $538K (126,603 x $4.25), a 2.2x multiple on the original investment
  • The 20% option pool is 412,000 shares vs. 377,377 before. 
  • The seed investors own 517,733 shares which is $2.2 million divided by $4.25

Here is the new seed round cap table with the note converted into equity:

Here is the summary:

Notice the post-money valuation is $8.7 million.  Why is it not a sum of $6.0 million pre-money and $2.2 million raise?  Because we include the angel investor in the fully-diluted post-money amount.

The shark's $400K investment for 4% is similar to the previous example.  The pre-money valuation is still $10 million but the per share value is now $4.86, which is $10 million divided by 2,056,336 shares.  With that, we calculate the number of shares the shark's own at 82,253, which is $400K divided by $4.86. Here is the cap table:

And the summary:

What can we take away from this example using a convertible note?

PROS:

  • Gives company the ability to raise money without having to negotiate on valuation at such an early stage
  • Investors can be handsomely rewarded for the risk of investing at such an early stage

CONS:

  • If the convertible note is too large, there may be substantial dilution on conversion. That wasn't the case here.
  • This was a positive outcome, but in many cases, the investor can lose all their money
 

Disclaimer: I have no affiliation with Brightwheel. The example here is just that, an example, and is for illustrative purposes only.