When the time comes for you to convert your convertible note, you need to have a full understanding of the different conversion methods to be able to negotiate better terms with the investor.
There are 3 different calculation methods to calculate the price per share to which a note converts at, each differing in the variable being fixed.
In this video, we will dive into the third method, the dollars-invested method, often used as a compromise between the pre-money method and the percentage-ownership method.
In the dollars-invested method, the fixed factor is the Effective post-money valuation of the company which takes into account the money invested by the note holder. Effective post-money valuation is equal to the agreed-upon pre-money valuation (in our case $10 million) plus the dollars invested by the note holders (or $500,000) and the new investment of $1 million. At this stage we need to fix the price per share, using the Effective pre-money valuation. Assuming 1 million outstanding shares, the price per share is $10.5. Which is equal to the Effective pre-money valuation divided by the number of outstanding shares in this case $10.5 Million divided by 1 million equals $10.5.
Now that the price per share is fixed we can proceed with the calculation of the other variables.
New investors shares to be issued equals 95,238 shares
Conversion price for the note holder is $7.35 since it takes into account the 30% discount rate.
New shares to be issued for the note holders equal 68,027 shares. (Illustrate by showing the equation. Note holder amount $500K divided by Price per share $7.35)
Now that you have issued 163,265 new shares, your total number of shares is 1,163,265
Ownership is then distributed as follows between
The Founder: 85.96%
The Note holder: 5.85%
The Investor: 8.19%
So what method should you use?
The pre-money method benefits the founder as they don’t get diluted as much as in the other methods.
The percentage ownership is the method that favors the investors and note holders. And finally, the dollar invested method is a compromise between the two other methods, where everyone gets slightly diluted. Generally, the percentage ownership is most often used, as new incoming investors have the most leverage. But founders and business owners must understand the difference between each method so they can negotiate a deal that works for all parties.
It may seem complicated at first, but don’t worry!
The hub has a handy template that you can use to test these different conversion methods and find what works best for your company!