Convertible Notes: A Conceptual Perspective

There was a great discussion started by Mark Suster and Brad Feld around convertible notes and the many issues associated with a round in which they convert. This includes a hidden potential for a “multiple liquidation preference” if not adjusted for in the Series A and how the mechanics of the conversion could lead to differences in ownership than a new investor is expecting. Mark and Brad did a fantastic job walking through how the problem arises and the math that drives it.

I’d like to take a crack as to why, in theory, the treatment of the Notes in the pre-money valuation makes sense as the starting point. Of course everything can be a function of negotiation, as Brad points out, but it’s nice when positions have some grounding in principles, and I find many times entrepreneurs and investors can get frustrated by the advice “because that’s the way it is done”.

Let’s start with a discussion of valuation theory. In a perfect world, the value of a company is the sum of the FUTURE discounted cash flows that the business will generate over it’s life, discounted back to today. That discounted cash flow includes all expenses associated with operating the business in the future. The one assumption most Finance classes make is that the shareholding is FIXED for that analysis; however, in venture backed businesses, significant equity cost (dilution) is also required to build to those cash flows. If your share of an ownership is expected to decline over time, obviously you’d need to build in that dilution to your present value calculations. This is a subtle point but I’ll come back to it later. [Never mind whether we actually build models like these in VC or use shorthand methods, as this is a discussion of the principles.]

Convertible notes are used by a Company during its Seed to build to the current Series A valuation. The cash resources associated with them have been exhausted and any remainder is assumed in the current valuation. As such, they should be treated as part of the pre-money valuation — as part of the historical cost and cash flows that were sunk to get to a given set of assets and therefore valuation. Said differently, the expenses that the convertible notes would be funding have already occurred in the past and therefore no longer part of the future cash flows used to get to the current period valuation.  New investors are investing on top of, and building off of, that valuation.

If that’s too esoteric, here’s another way to think about it. If you were to have raised equity financing for your Seed, you would not add that invested dollar into the amount raised of the current round. Convertible notes are useful, so they say, because they are expedient and more efficient than an equity round, and are generally intended by investors to act in a similar manner (particularly where there are valuation caps). In any of these rounds, I have not heard seed investors negotiating for a more efficient way to get a multiple liquidation preference or asking future unknown investors to pay for their dilution. The treatment of convertible notes in the pre-money valuation would make it consistent with a round done as equity, which in the vast majority of times is the “spirit” of the creation.

The other way to look at convertible notes relates to my point above about how dilution must be accounted for in any valuation framework. The pre-money valuation has always, from the beginning of venture time, assumed the fully diluted share count. This is so the valuation captures any and all historical equity “cost” associated with building the company to this point when getting to a per share value (common stock, warrants, options, and … convertible notes). A convertible note clearly is an example of issuable shares that should form a part of the fully diluted share count, and therefore part of the pre-money valuation. New prospective shareholders set an “all-in” valuation so that they can clearly know the ownership they are buying in a company for a given dollar amount; everything from the past is not their burden to bear and should be resolved prior to their money coming in. This is exactly why many investors are clarifying the post money valuation and their ownership.

As an aside, I’ve sometimes been asked why is the Option Pool for future employees included in a pre-money valuation. Well, for the same reasons above, just as any valuation is assumed to be the present value of FUTURE cash flows (theoretically), it should also include FUTURE dilution. The future cash flows are generated by a certain set of employees, who require equity compensation as well as cash. The cash expense of those employees has already been incorporated by the future cash flows of the business (as expenses); similarly, the equity “cost” by way of dilution has to be be built in somewhere. This is where the Option Pool in the pre-money comes in. The market has settled out that 18 to 24 months is the reasonable range for the “options cost”, as that usually ties to the next milestone or round.

Hopefully the above offers some conceptual underpinnings to commonly discussed items. Practically speaking like anything else, everything is a matter of negotiation. The challenge is that the unintended consequences of convertible notes sometimes pit the un-informed against the ambiguous, leading to confusion. Sometimes it is helpful to understand the WHY to find a way out.

2 thoughts on “Convertible Notes: A Conceptual Perspective

  1. Nick says:

    So, two things. First, I like your use of Finance Theory to justify the attribution of the Convertible Debt in the Pre-money value to rationalize liquidation preferences and not give CD holders a large and undeserved windfall over then founders/common.

    Second, while I understand your comment about FIXED shareholdings, I actually don’t agree with your characterization. New money (equity or debt) changes several things: capital structure (liquidation of ‘value’ if you will), Future cash flows (presumably for the better) and the discount rate (more or less risky depends on a lot of factors). So then all those adjusted cash flows and risk result in a new company (hopefully higher) value which is attributed to various shareholders based on the order and size of their claims. But in general, you’re seeking investment to grow future cash flows and/or adjust risk, how you attribute that to specific investors (debt, preferred, common, etc) is a division exercise at the end…right? The opposite is true if you buyback shares with free cash flows…there is more future CF’s to be attributed to less shareholdings…

    • Amish says:

      The primary difference being the odds of a venture backed company doing a meaningful buyback is close to zero in proximity to a round (and perhaps for at least another decade ahead), while the likelihood of additional equity dilution in the next year is 100%.

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