That convert you raised last year is a part of your cap table

When it comes to convertible debt, I’ve had a few instances recently where “out of sight, out of mind” has created some misunderstandings around deal structures. Seemed like a good topic to cover here.

Given the prevalence of convertible debt as a seed financing instrument, an increasing number of companies we look at have some kind of convert in place. This is typically reflected on cap tables in a completely separate tab to the spreadsheet that shows the debt total by investor and then some kind of interest calculation. Of course many entrepreneurs naturally focus on the main tab of their cap table spreadsheet that shows ownership by founder, investor, etc and for them this is the starting point of negotiating a round. The problem, of course, is that their convert is already a part of their capitalization – even though it’s not reflected on the cap table.  There’s nothing nefarious here on the part of entrepreneurs, but I’ve recently been involved in a few situations where this key fact was skipped over and as a result their expectations for their ownership/total dilution of a subsequent equity round was completely wrong and because of that a deal (at least with us) didn’t come together (in one case the entrepreneurs viewed the convert as a post equity deal event, meaning that they thought they were negotiating a round with us that would then layer on the debt conversion – exactly the oppositie of how it actually works!).

When you raise $2M on a convert with a $6M cap you’ve sold 25% of your company (at least; 25% if this converts at the cap). And while your cap table may not yet reflect this in the numbers, your 40% founders equity stake is actually already 30% when you start the process of raising your equity round. It’s worth going through the math explicitly, as convert terms like this can have a significant effect on the total cap table. This is especially true when the round price is significantly higher than the convert cap. Raise $6M on an $18M pre and you think you’re selling 25% of the company. But factor in that convertible debt above and you’re actually taking more like 50% dilution from the ownership reflected on your pre-convert cap table. Not necessarily a bad deal, but if you didn’t have that in your head you’re setting yourself up for a big surprise. And keep in mind that the equity round will price in the convert (so in my example above the $18M pre includes the conversion of debt – but because the conversion price is capped, from a dilution perspective $4.5M of the pre-money is actually the debt conversion).

The math all adds up in the  end – but make sure you’re thinking it through all the way.

  • Charlie Wood

    *nefarious :-)

    • sethlevine

      thx. fixed! (not sure why that didn’t get flagged)

  • Amit Seth

    In India, we are increasingly seeing angles structure investments such that they get x% of net profit of the company post investment for y years (mostly till an institutional round) – thus putting more skin in the business though typical per cent revenue share demanded is upwards of 25%, and then having the terms of a typical convertible debt i.e. cap, preferred equity, etc. How would you gauge this from an angel and from an ecosystem perspective?

    • sethlevine

      I’ve heard of this, but haven’t seen it here in the states. Feels like double-dipping, unless the principal amount of the convert is worked down with the rev share). Still, it’s hard to split revenue when a company isn’t yet profitable (and not necessarily in the investors best interest, either).

  • Tom

    Great post here, glad I came across it. How would one account for a convertible debt investment in the cap table if there was no cap?

    Does one use the projected company value in that case and assume the Note is converted?

    • sethlevine

      The convert technical isn’t equity since it hasn’t converted yet (which I think is why many entrepreneurs forget about it). I think best practice is to build it into the cap table on an as converted basis where in the cap tabe you set the date of conversion and the price (with an on off switch to see it converted or not). That way you can play around with some different scenarios for how it converts and it’s very very clearly a part of the equation even if it hasn’t actually converted yet. Make sense?

  • steve donatelli

    Thanks Seth. Are you seeing any “Converts” done w/o a cap? Or are they called Bridge Loans?

  • Jesse

    Seth, can you explain how you got the $4.5M at the end? I think this is an important nuance that I don’t see people explaining much on the blogs. Thanks!

  • tommy carroll

    i dont understand how 2m into 6m follows with relinquishing 25% ownership, am i missing something here?

  • Sam Iam

    Has anyone explored some kind of an adjustable cap? It seems to me that the cap ought to reflect the effect of financings that are not “Qualified”. If additional equity flows into the company but does not trigger conversion, the noteholder gets a windfall, as the value of the company may increase above the cap not due to operational success but just due to equity investment. Example: $100k notes outstanding and a $1m cap; company raises $500k equity (or several smaller rounds) that is not “Qualified” under the notes. Conversion the day after the $500k equity investment nets the noteholder 10% of a company worth $500k more than it was worth the day before. This seems like a windfall, which could be avoided by increasing the cap by $500k. A simple anti-dilution-like mechanism. Or am I missing something?