If you just invested in the next big thing by way of a convertible promissory note, you will want to ensure that, when it converts, you get all of the equity to which you’re entitled. Does your note convert at the valuation set by new investors in the next financing? The valuation is typically expressed as the share price paid by investors in the next financing. Do you know how the share price of the next financing is calculated?
Let’s consider a simple example:
The company you invested in has 1,000,000 shares outstanding and you are the only note holder. Your note is worth $100,000 (principal and accrued interest). The investors in the next financing will invest $1,000,000 at a pre-money valuation of $4,000,000. In other words, the new investors expect to receive 20% of the company and, because you expect to convert at the same valuation as the next financing and your note is worth 10% of the amount being invested by the new investors, you expect to receive 2% of the company.
If your note is excluded from the calculation of the pre-money share price, the new investors will invest at a purchase price per share of $4.00 for 250,000 shares. If your note is then converted at the same price per share, you will receive 25,000 shares and thereby immediately dilute the new investors – the new investors will hold 19.60% of the company and you will hold 1.96% of the company.
But shouldn’t the new investors have received 20% of the company and you have received 2% of the company that now has a post money value of $5,000,000 for your $100,000? Theoretically yes, but because the new money was invested at exactly the same price as your note, both you and the new money diluted each other and neither of you obtained a $4,000,000 pre-money valuation.
It’s for this reason that your note must convert immediately prior to closing the new financing. The new investors should insist on it and so should you.
Let’s look at our example again but convert your note prior to the investment by the new investors:
If your note is included in the calculation of the pre-money value of $4,000,000, your $100,000 note should receive 2.5% of the shares outstanding prior to the new investors (i.e., $100,000 is 2.5% of $4,000,000). 2.5% of the company is equal to 25,641 shares. This means that the total number of shares outstanding before the new investment is 1,025,641. At a pre-money valuation of $4,000,000, each share is worth $3.90. This means that the new investors will receive 256,410 shares for their $1,000,000 investment.
By including the conversion of your note in the pre-money share price calculation, (a) the new investors received what they bargained for, i.e., 20% of the company for $1,000,000 investment; and (b) you received what you bargained for, i.e., conversion of your note at the same valuation as the next financing and 2% of the company post-financing.
The difference for you between the two calculations above is only 641 shares, but if your investment does turn out to be the next big thing, each one of those shares may be worth a lot more than $3.90 in the future!