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.