In the previous article, we looked into how the cap table works in simple terms. Let's try to dig deeper into different aspects of the cap table. Calculating the cap table becomes more complex when you have convertible notes converting into equity. For this example, let’s use the following assumptions about the financing and the terms of the convertible notes.
Agreed-Upon Pre-Money Valuation: $8 million
Agreed-Upon Post-Money Valuation: $10 million
Amount Being Invested by New Series A Investors: $2 million
Principal Plus Accrued Interest on Outstanding Promissory Notes: $1 million
Discount Rate for Conversion of Notes: 30%
Shares Outstanding on a Fully Diluted Basis, Pre Investment: 1 million
The important aspect of this is that we need to figure out when the convertible debt gets converted into equity, we have to look into the following 1) Whose ownership is diluted? 2) How much is it diluted?
Let's look into different methods to deal with this issue:
Pre-Money Method
In the pre-money method, the pre-money valuation of the company is fixed and the conversion price for the notes is determined based on that.
So the price per share will be $8/share ($8million / 1 million oustanding shares)
For the convertible debt, there will be a discount given to the investor. Who has invested before and compensates for the risk taken by the investor, also known as the "valuation cap."
The pre-money method causes both the founders and the Series A investors to be diluted by the shares issued upon conversion of the notes. While the pre money valuation stays fixed at $8 million, the post-investment percentage ownership of the Series A investors is 17.5% and the post money valuation implied by this method is $11.43 million. While this is probably the most common method, many investors dispute its use, since it results in them having less ownership of the company than that for which they believe they bargained
Percentage Method
In this method, the Investor purchases shares on the basis of percentage ownership of the company that the investor is purchasing is fixed, and the other variables are computed based on that. Here we fix the ownership (ie 20%)
