A company is given a term sheet for a Series A round which offers to purchase $5MM of preferred stock with a purchase price based on a pre-money valuation of $15MM and with pre-money shares of 10MM. What is the post-money valuation, percentage ownership, share price, and number of post-money shares?
Determining the answers to those questions can follow a certain intuition. The post-money valuation as the valuation after the new money should be equal to the pre-money valuation plus the new money introduced.
Given that the investor is buying up a portion of the valuation in its investment, dividing that investment by the post-money valuation will give the percentage ownership for that investor.
The price per share is the valuation divided by the number of shares. Here we are given the pre-money valuation and pre-money shares.
Given that the investor is buying new shares at their share price, dividing their investment by that share price should tell the number of shares they should be allotted from their investment.
Those new shares can be added to determine the post-money number of shares.
Those new shares do indeed represent the same percentage ownership of those post-money shares.
The share price can alternatively also be calculated by using the post-money valuation and dividing by the post-money shares.
Determining the answers to those basic questions can become considerably less intuitive when convertible securities are introduced.
Convertible securities are financial instruments that convert into different securities in accordance with certain conditions.
Convertible notes are bonds whose debt is redeemed in future stock issued.
Non-debt convertible securities (such as the Safe (Simple agreement for future equity — YCombinator 2013, revised 2018), KISS, among others) are warrants that represent a deferred issuance of stock.
Convertible securities can be useful in deferring the valuation of a company to a point where it can be more reasonably determined and can push off legal expenses and negotiations to a future priced round.
As a result, these instruments have become increasingly popular.
They have even crept into later rounds.
The reason that convertible securities can complicate a priced round is that the number of fully diluted shares will always add up to 100%. Determining ownership in relation to a later valuation can impact the ownership of others. Either the pre-money valuation will change or the shareholders for the priced round will own less — the new percentage ownership has to come from somewhere.
Some terms in a legal document that might be useful for an instrument to defer pricing around could be:
- Something that serves as a reference point at present to contextualize future valuations - a valuation cap — caps the valuation of a company (pre- or post- money) so that ownership at a certain point is equivalent to pricing the investment made at the capped valuation.
- Something that accounts for risk at early stages where pricing is difficult — a discount — discounts the share price at a specified rate (referenced in SAFEs through a discount rate which is 1 minus the discount) when compared to a qualifying round (most convertible securities will have an equivalent discount of zero so that the price cannot be higher than the round that qualifies).
- Something that accounts for the amount of time an investor has to hold a priced security — an interest rate — specific to convertible notes, accrues the balance for the amount considered invested at a defined rate.
- Something that determines when the security should convert — a trigger — will bring into effect the instrument upon any priced round for a safe (which is standardized) and can be defined as a specific amount of capital raised in a priced round for a convertible note.
Given the terms previously of a $5MM investment at a $15MM pre-money valuation and with 10MM pre-money shares, a convertible note can be introduced with a $188,679 amount invested with a 6% interest rate per year 1 year prior to the priced round with a valuation cap of $4MM.
The investment amount is determined from the initial investment amount and interest rate.
The amount of ownership that the priced round should have as defined earlier would be 25%, but the introduction of the convertible note adds an additional amount of shares.
The reference point of the valuation cap indicates that the investment would imply a 5.0% ownership stake of something. That ownership stake will not represent a 5.0% ownership of the entire company as dilution will take place with the priced round, but how the ownership percentages are broken down (in a capitalization table) is not quite as intuitive as previously without the convertible security.
Assuming the pre-money valuation is fixed at $15MM and that the number of shares defined as part of the pre-money associated with that valuation is the same as they would be defined were the convertible note not present (at 10MM), the number of shares would be determined in comparison to the Series A round as follows.
Instead of the 13.33MM total post-money shares without a note, this method of conversion will introduce an additional 500k shares (which represent 5% of the 10MM shares) for total post-money shares of 13.83MM. The percentage owned by the Series A investors is diluted (proportionally) along with the founders as the convertible securities are introduced.
That 13.83MM shares multiplied by the $1.50 share price implies a post-money valuation that is not fixed at the $20MM implied by the Series A round, but instead at an effective post-money valuation of $20.75MM. The pre-money valuation is still $15MM with a share price of $1.50 and the number of pre-money shares at 10MM. Because the pre-money valuation is fixed while the post-money valuation is not, this method is called the pre-money method of conversion.
An alternative to this method of conversion instead redefines the pre-money shares to include the convertible note itself and does not fix the pre-money valuation. Calculation of the number of pre-money shares involves the determination of the shares themselves and some simple algebra can be used to determine the pre-money shares from the definition of what is included in them.
That number of shares in total in the pre-money could be thought of perhaps a bit more simply as dividing the number of shares outstanding by 1 less the percentage implied as owned by the note holders from the investment and cap, but I think the first principles that can be used to derive that algebraically can be important to focus on as additional considerations can come into play.
The number of shares held by the convertible note can therefore be found as follows.
The number of shares held by noteholders in this example represents the 5% of the total pre-money now defined as 10.53MM beyond the original pre-money of 10MM.
The number of post-money shares and shares held by Series A investors can be found using similar principles.
The additional 3.5MM held by the Series A investors represents 25% of the post-money shares.
Here, the post-money shares (including everything) multiplied by the share price of $1.43 is equal to the post-money valuation of $20MM. The pre-money valuation as defined by including the convertible notes is the defined pre-money valuation of $15MM (because it includes everything but the new money), but since that does include the convertible note which does not convert until the new money comes along, the effective pre-money valuation multiplying the share price by the pre-existing shares of 10MM is $14.25MM. Since the post-money valuation is fixed while the effective pre-money valuation differs from what is already established, this method of conversion is said to be the post-money method (alternatively called since this results in the same percentage ownership for Series A investors as intended as the percentage ownership method).
One may notice that it is the same difference between the effective pre-money and the real pre-money and the effective post-money and the established post-money in the pre-money method and post-money method respectively. This can be used to simplify the differences here as well, but again, I think it’s best to rely on the first principles of what is included in the pre-money and what is fixed as a result to avoid potential confusion.
There is a third method of conversion that proceeds the same as the post-money method and fixes the post-money defining the pre-money to include the note, but which differs in that the post-money valuation is fixed to include the dollar amount invested (including interest) by the note (in addition to the pre-money valuation and amount invested by the qualifying investors). This method is called the dollars invested method.
Option pools can further complicate convertible security conversion.
Priced rounds will often include the following clause in a term sheet:
“The $[ ] pre-money valuation includes an employee stock option pool equal to [ ]% of the post-financing fully diluted capitalization.”
Their purchase price will include in the pre-money capitalization used to determine pricing, an option pool representing a fixed percentage of the post-money capitalization.
Investors establish an option pool to ensure that executives can properly incentivize employees with options.
Options contracts offer the opportunity for employees to purchase common stock at fixed price. As those options are distributed, employees can purchase stock at a value that can prove to be incentivizing, but at a fair market strike price do not represent a tax burden as opposed to were the employees gifted stock directly (below a fair market value at zero).
The incentives are not something that investors want to dilute their investment, so it is included as part of the pre-money valuation and the fixed percentage of the post-money valuation ensures a determination for what is appropriate incentives is tied to the capitalization and valuation of the business after raising.
A priced round with a $5MM raise on a $15MM pre-money valuation, 10MM shares of common stock, and an option pool representing 10% of the post-money valuation, could have a post-money capitalization determined as follows.
If there was already an option pool already in place, some of those options could be issued to employees already with the remaining shares in the pre-existing pool being unissued. The additional shares to be added to the unissued options in the post-money option pool is the option pool expansion.
Taking the same Series A round as before with a $5MM raise on $15MM pre-money valuation, with a 10% option pool, with 10MM shares outstanding including 9.25MM common stock owned by founders and with 100k unissued options and 650k already issued to employees, the post-money capitalization could be determined as follows.
The number of unissued options in the option pool post-money expands on the previous unissued options of 100k by 1.423MM to reach the final 1.523MM.
Below are few ways the introduction of option pools are handled in some convertible notes.
The issuance of convertible securities when option pools are present can complicate conversion.
Convertible securities can fit to a template, but convertible notes generally don’t need to conform to one, and an instrument like YCombinator’s Safe in 2013 helped to standardize convertible securities and simplify points of negotiation and conversion.
Safes help define what capitalization components of a company’s shares are considered in the conversion process for determining share price.
The safe was also constructed as a warrant rather than debt because debt may legally require a maturity date at which point terms can be renegotiated, adding complexity.
Safes also defined a qualifying round for their conversion as any round where there is an established price rather than a specified minimum for a trigger.
The safe was revised in 2018 to reflect changes in how they were being used and the capitalization basis (what components were included) adjusted. The new safe was designated as the “post-money safe” while the old safe was designated as the “pre-money safe” and the pre-money safe was removed from the YCombinator website.