Determining how much equity the convertible note holder receives is relatively complicated. Assuming conversion is triggered by a Series A, the first factor is the valuation used for the Series A. If the Series A investor buys 2,000 shares (and the company originally has 10,000 total issued and outstanding shares) for a $1,000,000 purchase price ($500 per share), this sets a pre-money valuation of the company at $5,000,000. Immediately following the Series A (ignoring the conversion of the note), this leaves a company with a post-money valuation of $6,000,000 with 12,000 outstanding shares.
Now let’s go back and convert the note. Imagine there was a convertible note in the original principal amount of $100,000 outstanding with an 8% interest rate. If the note was converted on the 1st anniversary of signing, the outstanding principal and interest would be $108,000. The next step is to determine whether the note will convert based on the discount rate (assume 20%) or the valuation cap. In this scenario, if the valuation cap were greater than 80% of the pre-money valuation, the note would convert based on the discount rate because that would yield a higher number of shares for the investor. Applying a 20% discount rate would cause the note to convert at a price of $400 per share (80% of the $500 per share purchase price). Upon conversion, the investor would receive 270 shares with a fair market value of $135,000. This would equate to a 35% rate of return for the investor, which isn’t bad but for many investors is still not enough return to justify such a high-risk investment.
Now in the above example, imagine the note included a very low valuation cap of $1,000,000 per share. In that case, the note would have converted based on a per share price of $100 per share. Upon conversion, the investor will receive 1,080 shares with a fair market value of $540,000. That equates to a 540% rate of return, which is the type of upside angel investors are targeting.
Finally, keep in mind that the note will typically convert into the same class of shares received by the Series A investor. Generally, most Series A investors will demand a liquidation preference equal to 1 to 2 times their original investment. In the case of a convertible note with a high discount rate or low valuation cap (relative to the Series A pre-money valuation), this could lead to a liquidation preference many times greater than the note holders original investment, which is arguably inequitable. For instance, in the second example above, if the Series A includes a 2X liquidation preference, the convertible note holder who invested $100,000 would receive 1,080 shares with a fair market value of $540,000 and a liquidation preference of $1,080,000! It is easy to envision scenarios where a subsequent sale of the company would not yield enough proceeds to even cover the liquidation preferences, thus leaving the founders with nothing! It is common for convertible notes to be offered on a “take it or leave it” basis and startup companies have little or no leverage. In many cases, it is better to obtain the necessary capital to get your business off the ground than to allow your business to stall for the principal of resisting the demands of potential investors. However, if you have any leverage in the negotiation of a convertible note, you may want to propose a provision which caps the liquidation preference associated with any conversion shares received by the note holder.