To recap, a convertible note is a form of short-term debt that later converts into equity.
Its primary advantage is that it does not force the founder or the investor to determine the value of the company, especially at times when the company may still be an idea.
That valuation will usually be determined during your next equity round, most likely your seed or series A financing round, which triggers the conversion of the note from debt to equity.
So how exactly does the conversion happen? What basis and factors should be taken into account?
There are 3 different calculation methods to calculate the price per share to which a note converts at, each differing in the variable being fixed: the Pre-Money Method, Percentage-Ownership Method and the Dollar Invested Method.
Let’s focus on the first methodology: The pre-money method.
In this method, the pre-money valuation, or the company valuation that is determined during your equity round before receiving any financing, is the variable that gets fixed.
This allows you to calculate the price per share, which in turn helps you find the number of shares the convertible note holder and the new investor will eventually receive.
Let’s say you own 1 million shares in your company and you issued a $500,000 convertible note, with an agreed on 30%-discount rate upon conversion, with no interest rate or cap value to simplify the calculations.
After a year or two, you raise a Series A round of funding – $1 million from a new investor and your pre-money valuation was estimated to be around $10 million dollars.
So the question is, how many new shares will you need to issue for each, the investor and the note holder?
This method first finds the price per share by dividing the fixed variable (or your pre-money valuation) by the initial number of shares. In our case, we divide $10M by 1 million shares which results in $10 as the price per share.
Now that we have the price per share, we can calculate the number of shares, both the new investor and the convertible note holder will receive.
This new investor will receive shares for the value of $1 million - their initial investment - divided by the price per share we just calculated which is $10, to receive 100,000 shares.
For the convertible note holder, the same calculation applies but we need to take a pre-agreed discount rate into consideration.
In this case, the price per share would therefore be equivalent to the actual price per share with a 30% discount applied, or $10 multiplied by 0.7 resulting in $7 dollars per share.
The note holder will receive the equivalent of $500,000 - the money they initially lent - divided by the DISCOUNTED price per share we just calculated which is $7.
This translates to about 71,428 shares, many more shares than the 50,000 shares they would have received had they been regular investors instead of noteholders
Now, you, the founder, will still own 1 Million shares, while the investor will now own 100,000 shares and the note holder will own 71,428 shares.
In total, your company will now have 1,171,428 shares.
By dividing the number of shares for each shareholder by the total number of shares, you can calculate the ownership percentage allocated
to the founder: 85.4%
to the Investor: 8.5%
to the Note Holder: 6.1%
As explained, the pre-money method is one of the three methods you can use to convert the convertible note debt into equity.
Some investors prefer to use the Percentage-Ownership Method or the Dollar Invested Method instead, since the pre-money method is advantageous toward the founder and it is usually hard to convince investors to use this method, since it results in a higher ownership percentage for the company owner.
Check out the Hub to learn more about the other two methods.
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