First, a disclaimer: I am not a lawyer or a financial advisor and am not offering financial or legal advice.
Raising money via convertibles
The issuance of Convertible notes and SAFEs do not yet give the owners of those instruments ownership of shares, just the right to purchase at a time in the future at a price to be determined. Convertible notes and SAFEs are generally converted into equity when an equity round is raised, purchasing shares with the same rights as the new equity round, but usually for a different price.
Who bears the dilution
The key to understanding converting SAFEs and convertible notes is understanding who bears the dilutive effect of issuing the new shares to the investors in the convertible.
- All shareholders, including new equity shareholders investing in a round
- Existing shareholders prior to the round
- Some mixture of the two
Legal documents will typically specify how to calculate share prices in a conversion, specifying exactly how to treat different share classes.
Calculating the price per share
The most important thing to calculate is the share count to use in calculating the price per share that each investor pays, and it will vary depending on the terms of their investment structure. Each different structure has a different default method for what is included in the share count, and can vary case-by-case depending on the specifics in the legal documents. Legal documents will specify how to calculate share prices in a conversion, specifying exactly how to treat different share classes.
What’s generally included in the share count to calculate share prices for issuing shares?
When calculating the share count for each type of investment vehicle, it's important to note how the legal documents define the company capitalization differently:
Issuing new Equity
- Fully-Diluted Shares prior to the funding round
- If investor friendly method, shares issued through all Premoney SAFEs and Convertible Notes
- If converting a postmoney SAFE, all shares issued to postmoney SAFEs
- If investor friendly method, new options issued through creating or expanding the option pool
Converting Postmoney SAFEs
- Fully-Diluted Shares prior to the funding round
- All Shares issued through converting Postmoney SAFEs and other convertibles
Converting Premoney SAFEs and Convertible Notes
- Fully-Diluted Shares prior to the funding round
- New options issued through creating or expanding the option pool
Fully Diluted shares includes issued and outstanding shares + current authorized options
Increasing the share count creates dilution
When the company bears the dilution of converting convertibles or issuing new options, we calculate that by including the number of those shares in the denominator when we calculate the share price. That reduces the real valuation that a company is getting, and reduces the share price a new equity investor pays for their shares.
The “effective premoney” is a term used to describe the real valuation that a company is getting on a new investment round.
Premoney valuation minus the value of the dilution borne by existing shareholders equals the “effective premoney”.
Conversion should be evaluated in concert with valuation
How to convert is a negotiation on how to treat the impact of dilution.
Example: $3mm new investment at $17mm premoney with $2mm unconverted convertibles
Potential outcomes for new investor from conversion:
- $3mm / ($3mm + $17mm) = 15% expected ownership from postmoney conversion
- $3mm / ($3mm + $17mm + $2mm) = 13.6% ownership from premoney conversion
If negotiate how conversions are handled, and make the result equivalent by changing the agreed premoney valuation:
Example same situation, but $15mm premoney
- $3mm / ($3mm + $15mm + $2mm) = 15% ownership from premoney conversion
How to convert a Postmoney SAFE
A postmoney SAFE conversion is effectively treated as converted first before an equity round, using a cap or discount rate to determine how many shares they convert into.
From a calculation perspective, it’s easiest to think of it as “first convert the SAFEs, then issue the equity”
Dilutive impact of the SAFEs are borne entirely by existing shareholders (typically, the founders and management holding common shares)
How to convert a Premoney SAFE and Convertible Note
Think of converting a premoney SAFE and a convertible note as the conversion occurs at the same time as the equity issuance.
Multiple methods:
- Premoney method (postmoney conversion), often called “founder friendly”
- % Ownership, or Postmoney method (premoney conversion), often called “investor friendly”
- $ Invested method
The difference between the methods is who bears the dilutive effect of the convertibles, and how much dilution they bear.
Legally, there are many differences between a premoney SAFE and a convertible note, but in terms of calculating conversions they use the same methods and sets of calculations.
Two main things to note on notes:
- Handling payment or conversion in absence of a qualified financing. In event of an exit or a conversion at maturity date, how should a convertible note be handled? SAFEs do not have a maturity date so they typically do not have the same terms around conversion outside of an exit or financing event. Typically there are terms in notes that define how notes are paid, often at a multiple of the outstanding principle (plus accrued interest).
- Converting interest. Typically interest is accrued and added to the balance at conversion.
Premoney method (through a postmoney conversion), “founder friendly”
The price per share of the equity is first calculated using the issued and outstanding shares, then the price per share of the convertibles is calculated.
This spreads the dilution impact of the convertibles (”issuing them shares”) across existing and new investors, leaving the new investor purchasing a smaller ownership post-conversion than they expected in the round.
e.g. an investor invests $1mm on $10 mm postmoney to purchase 10%, but then once the convertibles are issued they get < 10%.
Percentage Ownership method (premoney conversion), “investor friendly”
The price per share of the equity is calculated by dividing the premoney valuation by issued and outstanding shares + the shares to be issued to the convertibles.
This forces the dilution impact of the convertibles (”issuing them shares”) onto existing investors entirely, leaving the new investor purchasing what they expected based on their investment amount and postmoney valuation.
Practically, you can also calculate this using an “effective premoney” by calculating the full dilutive value of the convertibles, and subtracting it from the negotiated premoney.
Dollars Invested method
The price per share of the equity is calculated by dividing the premoney valuation by issued and outstanding shares + the shares to be issued to the convertibles from the conversion discount.
This shares the dilution impact of the convertibles (”issuing them shares”) across existing and new equity investors, an in-between solution between the previous two methods.
Practically, you can also calculate this using an “effective premoney” by calculating the dilutive value of the conversion discount, and subtracting it from the negotiated premoney.
Great resource for the above methods, Calculating Share Prices with Outstanding Convertible Notes or SAFEs.
Founder-friendly and Investor-friendly
The terminology of premoney and postmoney is confusing and opaque to people new to the topic. I always focus on thinking about in terms of investor-friendly or founder-friendly, from the perspective of who bears the dilution.
While there are multiple methods for calculating conversions, it is common to use premoney conversion as a standard approach to converting premoney SAFEs to put the dilution on existing shareholders.
As a note, you won’t see these methods named in a legal document. Instead, you’ll see a definition of what shares are included in the calculation of the Safe price, and that is what impacts dilution. Thus, always read the legal docs to see how to calculate the conversion, as templates are often modified for specific situations.
Legal documents tell you how to convert convertibles
Look for the definitions of these terms:
- Purchase Amount: amount being invested in the Safe by the investor
- Standard Preferred Stock: stock issued to new equity investor when the Safe converts
- Safe Preferred Stock: stock issued to the Safe investors when the Safe converts, typically with the same rights of Standard
- Preferred Stock but with different liquidation preferences
- Safe Price: if a valuation cap is in the docs, the price per share paid for the Safe preferred stock, typically defined as the - Valuation Cap divided by Company Capitalization
- Discount Price: if a discount rate is in the docs, the price per share paid for the Safe preferred stock calculated using the discount rate
- Company Capitalization: how to calculate the number of shares used in calculating share prices (e.g. the denominator in premoney valuation / number of shares)
- Equity Financing Event: sets how the SAFE is converted into shares, typically noted as the greater number of shares calculated by (1) the Purchase Amount divided by lowest price per share of the Standard Preferred Stock or (2, if applicable) Purchase Amount divided by Safe Price or (3, if applicable) Purchase Amount divided by Discount Price
Glossary
Below are a number of common terms used in cap tables around convertibles.
| Term | Definition |
|---|---|
| "Converting Investments" | Convertible notes and SAFEs are converted into equity when an equity round is raised, purchasing similar shares as the new equity round, but usually for a different price |
| Percentage Ownership | Shares owned by an investor / Fully-diluted shares, representing the percentage of the shares owned by the investor |
| "Effective Premoney Valuation" | The real valuation that a company is getting on a new investment round. Premoney valuation minus the value of the dilution born by existing shareholders = “effective premoney” |
| Convertible Note | Debt that has the right to convert into equity upon a milestone (a date or a significant financing event). Treated as unsecured debt, with the seniority of debt and rights to repayment. Can include a discount rate (right to purchase shares at a discount to the equity price), a cap (a max valuation paid at the time of conversion), an interest rate (typically accrued, and converted into equity or paid at time of conversion), and a maturity date (a date it has to be converted by, which can be renegotiated in practice). |
| Premoney SAFE | Essentially treated as a warrant to purchase shares, not treated as debt. Created to be simpler and easier (simpler docs) and standardized, to reduce legal costs and complexity. Can have cap or discount, no interest rate, no maturity. Introduced by Y Combinator in 2013. |
| Postmoney SAFE | Introduced by Y Combinator in 2018 (Download default documents.) Created to provide clarity on ownership, by defining the exact conversion method. Effectively adds antidilution protection for investors. Removed prorata rights, which can be negotiated as a side letter |
| Valuation Cap | Understanding the valuation cap |
| Discount Rate | Discount for purchasers of shares through convertible instruments, allowing the purchaser to pay the price per share for the equity shares * the discount rate = the price per share paid by the owners of the convertible instruments. Legal documents will usually cite the discount rate differently than we commonly talk about it, so be careful to make sure it's (1 - discount rate) * price per share or (discount rate) * price per share |
| Interest Rate | Convertible note and interest rates |
| Investor Friendly | Refers to a method of issuing options or shares from convertibles where the dilution incurred from those events is borne entirely by existing shareholders prior to the round, and not the new equity investors |
| Founder Friendly | Refers to a method of issuing options or shares from convertibles where the dilution incurred from those events is borne entirely by all shareholders, including the new equity investors |
| "Convert in the premoney" | "In a pre-money conversion the notes convert first, and are included as part of your company's value in the pre-money valuation. You may also hear pre-money conversion referred to as "the percentage-ownership method". |
| "Convert in the postmoney" | "In a post-money conversion, the incoming series goes first, then the note holders convert increasing the post-money valuation of the company. Because the pre-money value does not include the note holders, it gives a fixed price for the new round shares and so post-money conversion is sometimes (confusingly) referred to as "the pre-money method" when looked at from the perspective of the new investors." |
| Premoney Conversion Method | "Convert in the postmoney", or "Founder Friendly", |
| Percentage Ownership Conversion Method | Premoney Conversion Method, or "Convert in the postmoney", or "Investor Friendly", covered by Cooley. |
| Dollars Ownership Conversion Method | Methof for converting convertibles, covered by Cooley. |