The other day, Mark Suster wrote a critically important post titledOne Simple Paragraph Every Entrepreneur Should Add to Their Convertible Notes.Go read it – I’ll wait. Or, if you just want the paragraph, it’s:
“If this note converts at a price higher than the cap that you have been given you agree that in the conversion of the note into equity you agree to allow your stock to be converted such that you will receive no more than a 1x non-participating liquidation preference plus any agreed interest.”
I also have seen the problem Mark is describing. As an angel investor, I have never asked for a liquidation preference on conversion that is greater than the dollars I’ve invested. But, I’ve seen some angels ask for it (or even demand it), especially when there is ambiguity around this and the round happens much higher than the cap. The entity getting screwed on this term are the founders, who now have a greater liquidation preference hanging over their heads than the dollars invested by the angels. Mark has a superb example of how this works on his blog.
We’ve been regularly running into another problem with doing a financing after companies have raised convertible notes. Most notes are ambiguous as to whether they convert on apre-money or apost-money basis. This can be especially confusing, and ambiguous, when there are multiple pricecaps. There are also some law firms whose standard documents are purposefully ambiguous to give the entrepreneur theoretical negotiating flexibility in the first priced round.
If the entrepreneur knows this and is using it proactively so they get a higher post-money valuation, that’s fair game. But if they don’t know this, and they are negotiating terms with a VC who is expecting the notes to convert in the pre-money, it can create a mess after the terms are agreed to somewhere between the term sheet stage and the final definitives. This mess is especially yucky if the lawyers don’t focus on the final cap table and the capitalization opinion until the last few days of the process. And, it gets even messier when some of the angels start suggesting that the ambiguity should work a certain way and the entrepreneur feels boxed in by the demands of his convertible note angels on one side and priced round VC on the other.
The simple solution is to define this clearly up front. For example, inthe Mattermark investment from last year, I said “We are game to do $5m of $6.5m at $18.5m pre ($25m post).” When I made the offer, I did not know how the notes worked, what the cap was, or what the expectation of the angels were. But when Danielle Morrill and I agree on the terms, it was unambiguous that I expected the notes to convert in the pre-money.
In contrast, in the Glowforge deal, which Dan Shapiro talks about in his fun postGlowforge Completed its Series A with an Investor we Never Met, I was less crisp. I knew that Dan’s notes were uncapped with a discount and I knew his lawyer well, so I didn’t define the post-money in this case. Since the notes were uncapped, I expected them to convert into the pre-money. But I didn’t specify it. The notes were ambiguous and we focused on this at the end of the process after docs had gone out to the angel investors. Rather than fight about this, I accepted this as a miss on my part and let the post-money float up a little as a result. The total amount of the notes was relatively small so it didn’t have a huge impact on the economics of the investment but we could have avoided the ambiguity by dealing it with more clearly up front.
Recognize that this is simply a negotiation. In Mattermark’s case where there were a lot of notes stacked up, I cared a lot about the post-money. In Glowforge’s case where the note amount was modest, I didn’t care very much. And, while I care a lot about my entry point as an early stage investor, I’ve learned not to optimize for a small amount in the context of a pricing negotiation.
I think we are just starting to see the complexity, side effects, and unintended consequences created by the massive proliferation of convertible notes over the past few years. I’m pretty mellow about them as I’ve accepted that they are part of the funding landscape, in contrast to a numberof angels and VCs who feel strongly one way or the other. As derivative note vehicles have appeared, such as SAFE, that try to create synthetic equity out of a note structure, we’ll see another wave of unintended consequences in the next few years. As someone who failed fast at creating a standardized set of seed documents in 2010, I’ve accepted that dealing with the complexity and side affects of all of the different documents is just part of the process.
Fundamentally, it’s up to the entrepreneur to be informed about what is going on. I hope Mark’s blog post, and this one, are additive to the overall base of entrepreneurial knowledge.And, ifJason and I ever write a third edition of Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalistour chapter on convertible notes might now be two chapters.
FAQs
Convertible notes can be designed to convert pre-money or post-money. In the next funding round, the notes might be set up to convert before any new investor's stake is accounted for, meaning the value of the note is included in the pre-money valuation in financing discussions.
What is the difference between pre-money and post-money? ›
Pre-money and post-money are both ways of valuing companies. The difference between them is the timing of the valuation. Pre-money valuation is the value of a company before any external funding, or before the latest round of funding. Post-money valuation includes outside financing or the latest capital injection.
How to calculate pre-money and post-money valuation? ›
Here's the basic equation:
- Pre-Money Valuation + Financing Proceeds = Post-Money Valuation. ...
- Pre-$ Valuation + Financing Proceeds = Post-$ Valuation. ...
- Pre-$ Valuation = Post-$ Valuation – Financing Proceeds. ...
- Post-$ Valuation = Financing Proceeds / Post-Financing Ownership Percentage.
Types of Pre-Money Valuations
1. Discounted Cash Flow (DCF): DCF helps companies and investors understand the value of a potential investment by analyzing projected future cash flows. Investors can use DCF to determine the amount of money they may receive by investing in a company.
What are the cons of convertible notes? ›
The following are just a couple of the possible disadvantages of using convertible notes as a financing mechanism. If they don't convert, the notes eventually come due. This can result in the end of the startup if the note holders aren't willing to negotiate, and the startup doesn't have the means to pay off the notes.
Why do investors prefer convertible notes? ›
In addition to getting the benefit of the accrued interest, which buys the convertible note holders more shares than they would have if they had waited and invested the same amount of money in the equity round of financing, they often get several additional perks in exchange for investing earlier.
What is pre-money and post-money safe? ›
The difference between the Pre-Money and Post-Money SAFE is that with a Pre-Money SAFE, the conversion into equity does not include the conversion of the SAFEs in its calculation. Consequently, a Post-Money SAFE does include the conversion of the SAFEs in the equity calculation.
What is the formula for pre-money to post-money? ›
PPS) = pre-money value / fully diluted capitalization
Example 1: BigVC is going to invest $2 million into GiantCo based on an $8 million pre-money valuation. After the investment, BigVC will own 20 percent of GiantCo ($2 million equals 20 percent of GiantCo's $10 million post-money value).
What is the meaning of post-money? ›
Post-money valuation is a company's estimated worth after outside financing and/or capital injections are added to its balance sheet. Post-money valuation refers to the approximate market value given to a start-up after a round of financing from venture capitalists or angel investors have been completed.
How to determine your pre-money valuation? ›
The basic formula for calculating pre money valuation is as follows: pre-money valuation = post-money valuation - investment amount. This is calculated on a fully diluted basis, and as such, all warrants and options issued are taken into account.
You use this as a compromise between the pre-money method and the percentage-ownership method. Here your post-money valuation is fixed to equal the agreed upon pre-money valuation plus the dollars invested by the new investors plus the principal and accrued interest on the notes that are converting.
How is pre-money valuation safe calculated? ›
Under the pre-money SAFE, the conversion price is calculated as follows: Conversion price = Pre-money valuation cap / company's capitalisation (or a total number of shares before the new investment round and excluding all SAFE investments to be converted).
Is pre-money or post-money valuation more important? ›
Pre-money is the valuation of your business prior to an investment round, while post-money is the value of your business after an investment round. Because post-money is the value of the company after every factor has been considered, agreed upon, and added up, it is simpler for investors.
What is the average pre-money valuation? ›
For early stage companies (typically defined as companies that are pre-revenue or have only generated seed funding), pre-money valuations tend to fall in the $2 million to $10 million range.
Does pre-money valuation include debt? ›
Since the pre-money valuation reflects the valuation of the company as a stand alone entity, this value is reflective of all of the value creating and detracting factors.
What is the conversion method of convertible notes? ›
Generally, convertible notes convert into shares (the “Conversion Shares”) at a qualified equity financing round (this term should be defined in the note and usually means a preferred financing round of a minimum size) at the lower of two different prices per share: (1) the price per share using the conversion cap ( ...
How does a convertible note convert? ›
Convertible notes are a type of loan issued by startups that convert into equity once a “triggering event” occurs. Usually, the triggering event will be the startup's next round of financing that exceeds an agreed-upon minimum threshold, i.e. “qualified” financing round.
How are convertible notes valued? ›
The basic concept for valuing a convertible note is the same in theory as the valuation of any other financial asset. The value of the note is equal to the present value of the future income that the convertible note will receive, discounted to the present value based on its associated risk.
Does pre-money valuation include convertible debt? ›
The round investors cannot suffer any dilution arising from the conversion of convertible notes and the price they will pay for each share is calculated by dividing the pre-money valuation by the number of shares into which the fully diluted share capital is divided (which include the convertibles).
