This post provides an overview of how a Convertible Note (CN) converts during a priced round (such as a Series A or B) and how ownership percentage changes as a result. There are several parameters to consider when evaluating a CN, including the discount rate, valuation cap, interest rate, and maturity date. The CN can convert in three ways: the pre-money method, percentage ownership method, and dollars invested method. This post focuses on the pre-money method, where the pre-money valuation of the company is fixed and the conversion price for the note is calculated based on that.
Assuming a pre-money valuation of $10 million, a CN principal plus accrued interest of $1 million, a 20% discount rate for conversion of notes, and a valuation cap set at $6 million, this post calculates the value of the CN after a $2 million Series A investment. The CN value is calculated using both the discount rate and valuation cap options, and the CN investor chooses the valuation cap option. The post-money valuation of the company is then calculated as the sum of the pre-money valuation, Series A investment, and CN value, resulting in a post-money valuation of $13.67 million.
Assuming a 10% ESOP, the effective pre-money valuation is calculated as the pre-money valuation minus the ESOP, resulting in an effective pre-money valuation of $8.63 million. The share price is calculated as the effective pre-money valuation divided by the number of shares outstanding pre-investment and pre-ESOP, resulting in a share price of $8.63. The share price for the CN holder is calculated using both the discount rate and valuation cap options, and the CN holder chooses the valuation cap option.
The number of shares issued in the Series A is calculated as the Series A investment divided by the share price, resulting in 231,660 shares. The number of shares for the CN investor is calculated as the CN principal plus accrued interest divided by the share price for the valuation cap option, resulting in 193,050 shares. The number of shares for the ESOP is calculated as the ESOP percentage of the post-money valuation divided by the share price, resulting in 158,301 shares. The total number of shares is the sum of shares for the founders, ESOP, CN investor, and Series A investor, resulting in 1,583,012 shares.
The ownership percentages are then calculated based on the number of shares each party holds divided by the total number of shares. The founders own 63.2%, the ESOP owns 10%, the CN investor owns 12.2%, and the Series A investor owns 14.6%
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