How to Convert Convertible Notes

An article we liked from Thought Leader Alexander Jarvis of Medium:

Convertible note conversion math at Series-A.

You don’t know how it really works!

You’ve raised a convertible note and now you are hitting series-A. Time for those notes to become equity. Now convertible note conversion math is tricky at the best of times, but what you don’t know is there are in fact three ways that conversion can be calculated!

Huh? That’s right 3! Not the one way you presumed, if in fact you though about this at all?

In this blog we are going to get into the math of conversion calculations and at the end of it, you’ll not only be smarter than a 5th grader, but smarter than most investors.

It begins. Your first angel round is typically a convertible note

You and your merry band of hackers got a product out, some light traction and attracted $1m from Angel investors.

The convertible note from angels is structured up as a:

• $1m convertible note (with some interest rate. Let’s assume it adds up to $1m to keep simple where we can)
• 30% discount rate (Yeah, not super, but you needed the money so you took it)
• Cap at $7m (Well, you got a fairly good cap as things go)
• Maturity etc we are not going to deal with here as it’s not useful for math

You agreed that the convertible note is going to convert at the series-A (“Qualified financing”).

The series-A is happening! Time to convert the convertible note

Congrats, so you are beating the odds and ticking nicely along. You have been growing well, put together a good pitch deck (having checked out other super examples), pitched like crazy and got a term sheet from super top notch series-A investors.

The headline financial terms the series-A VC offered you are:

• $8m pre-money
• $2m investment
• $10m post-money
• 10% post investment ESOP pool to be created
• Note: assume you have 1m shares outstanding (basically the # shares the founders have. Do not assume you have an ESOP already)

Now what? Who owns what?

You are probably aware that convertible notes convert from a debt instrument into actual ownership of your startup (shares; likely preference not common), dependent on a future valuation. The convertible note is often used to defer conversation about this valuation to the series-A where a VC sets the valuation. In this case, that valuation is the series-A (qualified financing).

For you to comprehend the math, you need to change your paradigm from headline valuation (pre or post money valuation) to that of a price per share (which is your valuation per share). As an analogy, if you trade and analyse public companies you note the EPS (earnings per share) which is the... 

Read the rest of this article at medium.com...

Thanks for this article excerpt and its graphics to Alexander Jarvis of Medium.

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