First, a disclaimer: I am not a lawyer or a financial advisor and am not offering financial or legal advice.
In Waterfalls I detail how to create a waterfall analysis to determine how the proceeds from an exit event are allocated to equity shareholders. What happens if there are investors that do not yet own shares? That can happen with unconverted convertibles, when investors hold convertible notes, premoney SAFEs, postmoney SAFEs, or other convertible instruments that have not yet converted into equity, and when a company has an exit event prior to a conversion to equity.
For converting convertible notes and SAFEs in an equity round, see Convertibles
In a normal exit waterfall analysis, the core part of the calculations is the test for each preferred shareholder to see if they should take their liquidation preferences (keep the distributions due to their preferred shares) or convert their preferred shares to common shares, and take the distributions due to all common shareholders.
How to model unconverted convertibles
Unconverted convertibles require an alteration to the normal exit waterfall analysis structure. Since the number of shares that the convertibles is unknown prior to the distribution, you have to add to the calculations the number of shares to issue to the convertibles if they convert into shares.
Thankfully, the legal documents for convertible notes and SAFEs have terms that define how to do this.
Premoney SAFE
Premoney SAFEs have terms that define how to handle the conversion of the SAFE into shares in the event of a liquidity event prior to a conversion event. From the premoney SAFE terms:
Liquidity Event. If there is a Liquidity Event before the expiration or termination of this instrument, the Investor will, at its option, either (i) receive a cash payment equal to the Purchase Amount (subject to the following paragraph) or (ii) automatically receive from the Company a number of shares of Common Stock equal to the Purchase Amount divided by the Liquidity Price, if the Investor fails to select the cash option.
In connection with Section (b)(i), the Purchase Amount will be due and payable by the Company to the Investor immediately prior to, or concurrent with, the consummation of the Liquidity Event. If there are not enough funds to pay the Investor and holders of other Safes (collectively, the “Cash-Out Investors”) in full, then all of the Company’s available funds will be distributed with equal priority and pro rata among the Cash-Out Investors in proportion to their Purchase Amounts, and the Cash-Out Investors will automatically receive the number of shares of Common Stock equal to the remaining unpaid Purchase Amount divided by the Liquidity Price.
If the premoney SAFE has a discount rate:
“Liquidity Price” means the price per share equal to: the fair market value of the Common Stock at the time of the Liquidity Event, as determined by reference to the purchase price payable in connection with such Liquidity Event, multiplied by the Discount Rate.
If the premoney SAFE has a valuation cap:
“Liquidity Price” means the price per share equal to the Valuation Cap divided by the Liquidity Capitalization.
“Liquidity Capitalization” means the number, as of immediately prior to the Liquidity Event, of shares of Capital Stock (on an as-converted basis) outstanding, assuming exercise or conversion of all outstanding vested and unvested options, warrants and other convertible securities, but excluding:
(i) shares of Common Stock reserved and available for future grant under any equity incentive or similar plan;
(ii) this instrument;
(iii) other Safes; and
(iv) convertible promissory notes.
As detailed above, the methods for calculating the share count in a liquidity eventmirrors the core of calculating the share counts to convertible holders in an equity raise.
Thus, in the calculations for the waterfall, we must first calculate the Liquidity Capitalization to calculate the Liquidity Price, and then use the Liquidity Price to calculate how many shares of common stock to issue to the convertible note and SAFE holders, if they convert. That if test is important, as it changes how we use the share counts in the waterfall.
Once we calculate the share price and shares, then we can use the waterfall as normal and do the same core calculations to determine if the SAFE holder should take their cash-out amount (liquidity preferences, or amount invested in the convertible) or convert the convertible into common shares.
The same structure applies for the Carta Premoney SAFE and other similar convertible instruments.
Postmoney SAFE
Postmoney SAFEs also have similar terms (from Y Combinator):
Liquidity Event. If there is a Liquidity Event before the termination of this Safe, the Investor will automatically be entitled (subject to the liquidation priority set forth in Section 1(d) below) to receive a portion of Proceeds, due and payable to the Investor immediately prior to, or concurrent with, the consummation of such Liquidity Event, equal to the greater of (i) the Purchase Amount (the “Cash-Out Amount”) or (ii) the amount payable on the number of shares of Common Stock equal to the Purchase Amount divided by the Liquidity Price (the “Conversion Amount”). If any of the Company’s securityholders are given a choice as to the form and amount of Proceeds to be received in a Liquidity Event, the Investor will be given the same choice, provided that the Investor may not choose to receive a form of consideration that the Investor would be ineligible to receive as a result of the Investor’s failure to satisfy any requirement or limitation generally applicable to the Company’s securityholders, or under any applicable laws.
If there is a discount rate:
“Liquidity Price” means the price per share equal to the fair market value of the Common Stock at the time of the Liquidity Event, as determined by reference to the purchase price payable in connection with such Liquidity Event, multiplied by the Discount Rate.
If there is a valuation cap:
“Liquidity Price” means the price per share equal to the Post-Money Valuation Cap divided by the Liquidity Capitalization.
“Liquidity Capitalization” is calculated as of immediately prior to the Liquidity Event, and (without double- counting, in each case calculated on an as-converted to Common Stock basis):
Includes all shares of Capital Stock issued and outstanding;
Includes all (i) issued and outstanding Options and (ii) to the extent receiving Proceeds, Promised Options;
Includes all Converting Securities, other than any Safes and other convertible securities (including without limitation shares of Preferred Stock) where the holders of such securities are receiving Cash-Out Amounts or similar liquidation preference payments in lieu of Conversion Amounts or similar “as-converted” payments; and
Excludes the Unissued Option Pool.
The calculations for the postmoney SAFE are very close to the calculations for the premoney SAFE, except that the share count used in the liquidity capitalization includes the shares issued to all unconverted convertible holders that choose to convert (if they do not convert, then they are not issued shares and they do not impact the liquidity capitalization).
Convertible Notes
Convertible notes are similar to premoney SAFEs, except for a couple key differences:
- Convertible notes have more variability in terms around how to handle payment of the note in a liquidity event prior to a conversion event, and thus it is important to read the note carefully to determine how to handle this situation.
- Convertible notes often have terms that will repay the principal of the note and any accrued interest plus some premium - either a defined amount, amultiple of the amount invested in the note, or some other approach - and this repayment will be done prior to the distribution to equity shareholders (thus, treated as a debt repayment prior to the distribution to equity).
Because of this, the waterfall structure will be a bit different, because you have to do the same core test - take the liquidation preferences or convert to common - but repay the note before the distribution to equity shareholders instead of paying the liquidation preferences through the equity distributions in the waterfall. Basically, the note either gets repaid as debt (comparable to taking the liquidation preferences) or it gets paid as a common shareholder (converting to equity).
Example models for waterfalls with unconverted convertibles
The Cap Table and Exit Waterfall Tool is prebuilt to calculate an exit waterfall for many different terms of preferred shareholders, but does not have a prebuilt option to handle unconverted convertibles at this time.
The Cap Table and Exit Waterfall Course and Cap Table and Exit Waterfall Masterclass, which teach beginning to advanced level techniques for modeling cap tables and waterfalls, both include segments of the course that cover this topic with instructional spreadsheets, and the video in this post uses sheets from those courses.
Questions on how to model unconverted convertibles, contact me anytime.