Convertible notes and convertible equity instruments, like Simple Agreement for Future Equity (SAFE), are supposed to be simple, straightforward, and not complex.
After all, they are only a handful of pages in length, right? How hard can they be?
Well, watch out. If you are a startup founder or CEO considering using a convertible note, a SAFE, or another type of convertible instrument; there is a little-known aspect of such instruments that can cost you a lot in equity dilution: the denominator.
More specifically, we are talking about what number of shares are included in the denominator, if you are doing a calculation of the valuation cap associated with conversion of a note or SAFE.
Let’s take a look at how this works.
The Ins and Outs of Convertible Notes
Often a standard convertible note or SAFE will contain a “valuation cap.” If there is a valuation cap, there is a chance your convertible note or SAFE could convert into equity, such as Series Seed Preferred Stock, at such valuation cap (rather than at some discount of the price the other purchasers in the financing are paying). If your instrument is going to convert into equity at the valuation cap, one question will be: How do we determine the price per share at which the amount invested will convert?
How to Calculate Conversion Price per Share
The formula to calculate conversion price per share is as follows:
Valuation Cap / Company Capitalization = Conversion Price Per Share
But how do you figure out the “company capitalization” (or number of shares) for the denominator?
This is where the specifics in your instrument will matter. They will tell you that you divide the valuation cap by a denominator that typically counts the capitalization in 1 of 3 ways:
All issued and outstanding securities on an as-converted to common stock basis. This would include issued and outstanding stock options (but not unissued shares reserved in the option pool), warrants, etc. (although theoretically you could only include exercisable options if you defined it this way).
All issued and outstanding securities on an as-converted to common stock basis, including the entire pool of shares reserved under the existing option plan.
All issued and outstanding securities on an as-converted to common stock basis, including the entire pool of reserved shares under the existing option plan and as increased in the equity financing.
The dilution impact on the founders based on these subtle verbiage changes can be dramatic.
The first scenario above is the most founder friendly, and the third is the most investor friendly, while the second is the middle ground. Keep reading for examples of the language you should look out for with convertible notes.
Convertible Notes Language to Look Out For
One form of convertible note, which is commonly used, says the following (this is the worst for startup founders):
Conversion upon a Qualified Financing. In the event that the Company issues and sells shares of its capital stock to investors (the “Investors”) on or before the date of the repayment in full of this Note in an arms-length equity financing resulting in gross proceeds to the Company of at least $250,000 (excluding the conversion of this Note or convertible securities issued for capital raising purposes (e.g., Simple Agreements for Future Equity)) (a “Qualified Financing”), then the outstanding principal balance of this Note and any unpaid accrued interest shall automatically convert in whole without any further action by the Holder into such shares sold in the Qualified Financing at a conversion price equal to the lesser of (i) 80% of the price paid per share for such shares by the Investors, or (ii) the price (the “Cap Conversion Price”) equal to the quotient of $3,000,000 divided by the total number of outstanding shares of the Company immediately prior to the Qualified Financing calculated on a fully diluted basis (assuming conversion of all convertible securities and exercise of all outstanding options, warrants, phantom stock, stock appreciation rights, and other rights to acquire capital stock of the Company, including any shares reserved and available for future grant under any equity incentive or similar plan of the Company, and/or any equity incentive or similar plan to be created or increased in connection with the Qualified Financing, but excluding shares issuable upon the conversion of the Note(s) or any other current or future convertible debt or equity instruments issued for capital raising purposes (e.g., Simple Agreements for Future Equity)).
For startup founders, these instruments should not include the bolded provision above, as it significantly impacts the valuation cap denominator in ways you may not have expected at issuance of the convertible instrument. Instead, a startup founder friendly way to structure the document is something like this:
Conversion upon a Qualified Financing. In the event that the Company issues and sells shares of its capital stock to investors (the “Investors”) on or before the date of the repayment in full of this Note in an arms-length equity financing resulting in gross proceeds to the Company of at least $250,000 (excluding the conversion of this Note or convertible securities issued for capital raising purposes (e.g., Simple Agreements for Future Equity)) (a “Qualified Financing”), then the outstanding principal balance of this Note and any unpaid accrued interest shall automatically convert in whole without any further action by the Holder into such shares sold in the Qualified Financing at a conversion price equal to the lesser of (i) 80% of the price paid per share for such shares by the Investors, or (ii) the price (the “Cap Conversion Price”) equal to the quotient of $3,000,000 divided by the total number of outstanding shares of the Company immediately prior to the Qualified Financing calculated on a fully diluted basis (assuming conversion of all convertible securities and exercise of all outstanding options, warrants, phantom stock, stock appreciation rights, and other rights to acquire capital stock of the Company, but excluding shares issuable upon the conversion of the Note(s) or any other current or future convertible debt or equity instruments issued for capital raising purposes (e.g., Simple Agreements for Future Equity)).
Y Combinator’s new Simple Agreement for Future Equity (SAFE)
Interestingly enough, in Y Combinator’s new SAFE (which is essentially a convertible note without the debt or interest component), YC cuts a middle path. They include the unissued option pool, but they specifically exclude “any increases to the Unissued Option Pool (except to the extent necessary to cover Promised Options that exceed the Unissued Option Pool) in connection with the Equity Financing.”
This methodology strikes a balance between the two scenarios above, in cases where option pools associated with financings are captured in the conversion calculation by the SAFE. Typically a convertible instrument will utilize the size of option pool prior to any increase in connection with a financing, rendering this language inapplicable, but there are some financing formulations where pools increased in connection with financings would be implicated, and in those cases this serves as a great protection to founders.
However, this new SAFE formulation is still not as startup founder friendly as omitting the option pool all together. Let’s go through a mathematical example.
How to Calculate SAFE Price per Share
Suppose the following key facts:
You and your Co-Founders own 2M shares in the aggregate.
You have set aside 300,000 shares in your equity incentive plan.
You raise $500,000 in convertible debt or equity with a valuation cap of $3M and a 15% discount.
You then raise $5M of seed capital at a $12M pre-money valuation.
Before your closing of your Seed Round, let’s say you have issued 115,000 options, leaving 185,000 shares available under the plan.
Your investors require, as a condition to closing the investment, that you increase your available stock option pool reserve by 100,000 shares, to a total of 285,000 shares available in the pool.
If you had the founder friendly document, the price per share would be $3,000,000/2,115,000, or $1.41843972.
(By the way, in this example, the price per share paid by the new investors would be $12,000,000/(2,000,000+115,000+285,000), or $5.00 a share.)
If you had the investor friendly document, the per share would be $3,000,000/(2,000,000+115,000+285,000), or a price per share of $1.25 a shares.
If your document utilizes the Y Combinator middle of the road approach, then the price per share would be $3,000,000/(2,000,000+300,000), or $1.30. Not as good as the founder friendly version, but not as bad as the investor friendly version.
The variation in the denominator language results in the convertible note holders getting a lot more shares, diluting the founders of a startup.
Depending on the size of your pool and the valuation cap at play, this difference could be even more pronounced. It is not uncommon for companies to raise notes initially at fairly low valuation caps, and for those caps to increase in size as the round continues. Very early note holders with low valuation caps can wind up getting a screaming deal.
Key Takeaways
The key here is to recognize the various inputs that come into play in terms of converting your convertible interests, and plan your cap structure strategy accordingly to minimize the unforeseen impact that these potentially small tweaks in legal language may have.
When you are converting convertible securities at a cap, for the startup founder, the answer is always better if the denominator is smaller. The bigger the denominator the lower the price per share and the more shares the convertible securities holders receive on a conversion.