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: the Pre-Money Method, Percentage-Ownership Method, and the Dollar Invested Method.
In our previous video, we explained the Pre-Money Method, its advantages and disadvantages.
In this video, we will dive into the second method:
The percentage ownership method:
The Percentage-Ownership Method is known as the investor-friendly method. The fixed factor is the percentage ownership that the new investor is purchasing. Let’s take the same example from the pre-money method discussed previously.
You own 1 million shares in your company and you issued a $500,000 convertible note, with an agreed on 30% discount rate upon conversion, with no interest rate or cap value to simplify the calculations.
After a year or two, you raise a Series A round of funding - $1 million from a new investor and your pre-money valuation was estimated to be $10 million dollars.
So the question is, how many new shares will you need to issue for each, the new investor and the note holder?
The percentage ownership method fixes the ownership amount of the new investor.
This amount is calculated in two steps:
Find your post-money valuation, which is equal to the pre-money valuation plus the new investment amount. Find the percentage ownership which is equal to the amount invested divided by the post-money valuation.
This means you agree to give away 9% equity to this new investor in exchange for the $1 million. This percentage is the starting point for your calculations. Now that you identified the percentage ownership for your series A investor, you need to find the price per share so that you can convert the note.
This is the tricky part because you need to test multiple prices to get to the right one.
But don’t worry; you can download the hub’s conversion calculator to do that.
By using our conversion calculator, we find that the price per share is $9.2858, and now we can calculate all the other variables. The number of shares to be issued to the new investor is the amount invested of $1Million divided by the price per share of $9.2858 which equals 107,692 new shares.
Now that we’ve taken care of the new investor, we also need to consider the note holder. The conversion price is $6.5 to the convertible note holder. When you do the math, this translates to approximately 76,922 shares. Now that you have issued 184,615 new shares, your total number of shares are 1,184,615.
Ownership is then distributed as follows between:
The Founder: 84.42%
The Note holder: 6.49%
And the Investor: 9.0%
The post money valuation of the company is $11Million dollar (Illustrate 1,184,615*9.29 = $11,000,000)
Investors usually push towards using this method as it works to their advantage.
However, founders and owners can feel like this method is a tad unfair, hence method 3 – the Dollars-invested conversion method.
Check out the Hub to learn more about the other two methods.