The Mechanics of Converting Convertible Notes

KEVIN VELA , Managing Partner , Vela Wood

6 Dec 2022

This post originally appeared on Vela Wood‘s blog.

Convertible notes are a great tool for venture financing. They are primarily used for early-stage financings, but they are also a good solution for a bridge round when a company isn’t quite ready for the next equity financing round.

The actual mechanics of converting convertible notes (in other words – calculating conversion shares) is not a simple task and requires great care. The conversion mechanics are dictated by the terms of the convertible note and may vary from note to note. For illustrative purposes, I’m going to break down how we calculate conversion shares at Vela Wood using circular references in Excel, based on our standard form convertible note (Note Gust Launch standard convertible note uses a interest rate of 5% and discount of 20%.). We’ve included a copy of our internal model to walk you through it. The model has two tabs. The first tab matches up with the example below. The second tab is for your personal use once you get the hang of things.

Note that you must have “iterative calculations” turned on in Excel. To do this, follow these steps:

PC – Click on “File,” then “Options,” then “Formulas.” Check the box in the upper right that says “Enable Iterative Calculation” and leave the default values.

Mac – Click on “Excel,” then “Preferences,” then “Calculation.” Check on “Enable Iterative Calculation” and leave the default values.

Generally, convertible notes convert into shares (the “Conversion Shares”) at a qualified equity financing round (this term should be defined in the note and usually means a preferred financing round of a minimum size) at the lower of two different prices per share: (1) the price per share using the conversion cap (known as the “Cap Price”) and (2) the price per share calculated by applying a discount to the price per share of the qualified equity financing round (known as the “Discount Price”). Such lower price is known as the “Conversion Price.” Note that not every convertible note has a “cap” and a “discount,” as it’s possible to have just one or the other.

Now, let’s walk through an example. For our example, assume these investment details (these are reflected in the first sheet of the Excel model):

>> Startup Inc. has 9,000,000 shares issued to the founders and 1,000,000 shares in reserve for an employee pool. This means a total of 10,000,000 shares currently issued, or reserved for issuance prior to conversion of the note.

>> 1 year ago, Annie Angel Investor invested $100,000 via a convertible note with a $5,000,000 conversion cap, 10% interest, and a 20% discount. (Note that 10% interest is high, but I’m using easy numbers for our example. A 20% discount is pretty standard.)

>> Startup Inc. is about to complete a $2,000,000 Series Seed equity financing round at an $8,000,000 pre-money valuation with Seed Ventures Inc.

>> Seed Ventures wants the post-transaction employee pool to be 10% of the fully-diluted ownership of the company. (Quick side bar about employee pools – even though Startup Inc. had 10% reserved prior to the investment round, all of the Startup Inc. shares will be diluted by the investment round, here through the conversion of the note AND the Series Seed investment, and thus the 10% employee pool will be less. Thus, the employee pool has to be grossed up to equal 10% on a post-transaction basis. This requires circular references and is built into the model.)

>> Seed Ventures Inc. thus expects to own 20% of the company post investment (because $2,000,000 investment + $8,000,00 pre-money valuation = $10,000,000 post-money valuation, and $2,000,000/$10,000,000 = 20%). I write this because we thus will have to include Annie’s Conversion Shares prior to calculating Seed Ventures’ purchase price, and this is tough to do. More on that below. (I will note that every once in a while, you’ll get an institutional investor who is okay being diluted by the convertible securities, but that’s not typically the case.)

Therefore, in order to calculate Annie Angel Investor’s Conversion Price, we must perform two separate calculations – (1) determine the price using the conversion cap (again, the “Cap Price”) and (2) determine the discounted price of the Series Seed equity financing round (or the “Discount Price”), and then take the lower price. Note that this is done in Excel using a “min” formula. Please see cell O26 of the model.

So let’s calculate those two prices and then see which one is lower.

CALCULATION #1 – CAP PRICE

The formula for calculating price per share using the conversion cap is the same one used when calculating price per share for an equity financing using the pre-money valuation.

The formula is Conversion Cap/Fully-Diluted Capitalization. Here is where many people make a mistake. They assume that, based on the assumptions above, the calculation is $5,000,000/10,000,000 or $.50 per share. Put another way, if the company has 10,000,000 shares worth $.50 per share, then the Company is worth 10,000,000 X $.50 or = $5,000,000.

But remember that we have to include the additional employee pool shares. (Again, the increased employee pool must be included in the fully-diluted capitalization based on this example, which is fairly standard. There are times, however, when the employee pool will not be increased or, rarely, the equity investor agrees to increase the employee pool post-transaction. Likewise, “fully-diluted capitalization” should be defined in the note and may or may not include outstanding warrants, other convertible securities, etc. Make sure you know what your “fully-diluted capitalization” is before starting any note conversion calculations.)

So if you will look at the model, you’ll note that in order to get to a 10% employee pool after the transaction, we need to add 318,158 shares. Thus, if you’ll look at cell O26 (which references cell K24), you’ll see that the correct calculation for the Cap Price is $5,000,000/10,318,158 or $.4846 per share (most people round to 4 digits, and that is noted in the Excel formula in cell O26).

CALCULATION #2 – DISCOUNT PRICE

Remember from our assumptions above that Annie Angel Investor purchased a convertible note with a discount of 20%. So, to determine the Discount Price, we take the price per share of the Series Seed shares (the “Series Seed Price”) and multiply it by (1- discount) or 80%.

But, here’s the catch – because Seed Ventures is investing on a fully diluted and converted basis, then we first have to calculate Annie’s Conversion Shares and include them in the Series Seed Price calculation. In order to determine the Series Seed Price, we need to know how many Conversion Shares there will be. But we can’t calculate Conversion Shares without knowing the Series Seed Price. This is where Excel’s circular reference tool comes in handy. Please see cell K32 in the attached model and note that the subtotal it uses includes the convertible note Conversion Shares.

Using the Excel model, we see that the Series Seed Price comes out to $.7586 once you include the Conversion Shares.

Thus, of our two calculated share prices, $.4846 is lower than $.6069 [$.7586*(1-.20)=$.6069], and leaves us with a Conversion Price of $.4846 (see cell O26). Now that we have a Conversion Price, we divide the outstanding balance of Annie Angel Investor’s note (here it’s $110,000 after $10,000 of accrued interest (see cell N26)) and divide it by $.4846. $110,000 / $.4846 = 226,991 Conversion Shares (see cell P26). (As a rule, we round share calculations down to the nearest whole share.)

I know this is a lot to digest and it’s complicated; this is why it’s critical to have a venture attorney who is comfortable doing these types of calculations to be sure you get them right. But hopefully this post and the Excel model will help you understand the process of converting notes and help you better plan for your capital raises.

About

Kevin Vela is the managing partner at Vela Wood. He focuses his practice in the areas of venture financing, M&A, fund representation, and gaming law. In recent years, he has represented both startups and investors in hundreds of convertible instrument and equity financing transactions ranging from angel rounds through Series C rounds.

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