By Paul B. Johnson and Aaron Sokoloff

With valuations in venture capital financings at historically high levels, companies are finding that “valuation caps” and other related terms in convertible notes and other convertible instruments are having a significant effect on company capitalization. For example, if entrepreneurs and investors do not consider the effects of outstanding convertible notes when negotiating the terms of an equity financing, there can be a disconnect between the pre-money valuation of the company and the post-financing ownership percentages. So how do convertible notes factor into a company’s capitalization in a financing, and how can entrepreneurs and investors understand and address these effects early on to avoid unpleasant surprises?

Typically, the post-money valuation for a financing is the sum of the pre-money valuation plus the amount of new money coming in. For example, if a company owned 100% by its founders receives a pre-money valuation of $10 million, and investors put in $5 million, then the post-money valuation would be $15 million. In this scenario, the investors would own 33.33% of the company on a post-money basis (i.e. $5 million divided by $15 million), leaving 66.67% for the founders.  But the existence of convertible notes can complicate this calculation.

For example, assume the same company also has $500,000 of convertible notes outstanding. Typically, convertible notes and other convertible instruments are set up to convert into equity at the company’s next financing. But there are at least two different potential approaches for how to account for the notes’ conversion, one of which is more founder-friendly and one of which is more investor-friendly. For simplicity’s sake, in the below examples, we are not taking into account any discount or cap on the conversion price of the notes.

1. Allowing notes to be considered part of the money invested in the financing: The amounts outstanding under the notes could be treated as new money coming into the round. The pre-money valuation would still be $10 million, but the investment amount would be $5 million of new money plus $500,000 of notes converting, so the post-money valuation would be $15.5 million (i.e. $10 million pre-money plus $5 million new money plus $500,000 in convertible notes). That would leave the founders keeping 64.52% ($10 million of $15.5 million), the new money with 32.26% ($5 million of $15.5 million), and the notes with 3.23% ($500,000 of $15.5 million) on a post-money basis.

2. Requiring notes to be part of the “pre-money” capitalization:  The new investor could insist in their term sheet that, regardless of whether any notes are outstanding, they will receive 33.33% post-money ownership. Therefore, the purchase price for their shares would need to be set so that the new investor still ends up with a third of the company on a post-money basis, taking into account the shares issued on the conversion of the notes. This means that the founders’ ownership percentage will be reduced, since the shares issued upon the note conversion must be “squeezed in” to the 66.67% of the company that is not owned by the new investor. This, in turn, means that the $500,000 under the notes must be included in the pre-money valuation. Effectively, the founders’ stock would be valued at $9.5 million and the notes at $500,000, to get a total pre-money valuation of $10 million. That would leave the founders with 63.33% ($9.5 million of $15 million), the new money with 33.33% ($5 million of $15 million), and the notes with 3.33% ($500,000 of $15 million) on a post-money basis. From the founders’ perspective, this results in a lower ownership percentage than in the scenario above.

Unfortunately, founders are usually unable to lock in the more founder-friendly approach when negotiating the convertible notes themselves, as it is typically the lead investor in the equity financing that drives the negotiation of how the notes are considered in the conversion.

The effects on ownership percentage can actually be much higher than the percentages in the examples above, because notes typically convert at a discounted price. The effect of these discounts is that $500,000 of notes may convert as if it were a higher amount of debt, and dilute the other shareholders accordingly. While discount rates usually range from about 10-30%, there can also be “caps” on the conversion price, which can result in a much higher effective discount rate.

It is important for entrepreneurs and investors to keep convertible notes and other convertible instruments in mind when they are calculating the pre- and post-money valuations for a financing in order to avoid surprises regarding post-money ownership.  In addition, entrepreneurs and their counsel would be advised to make sure any provision that requires the investor own a specified percentage of the company after the investment is clearly understood and accounted for in negotiating the term sheet, especially where convertible notes or other similar instruments are involved.