‍While convertible notes have many benefits, they also have certain drawbacks that are often overlooked or under-discussed. Based on our own experiences, we have encountered numerous situations where the use of convertibles has led to uncomfortable dynamics between ourselves, founders, and other investors. We believe these instances may be more prevalent than commonly recognized and wanted to highlight them in the article below.

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As a VC, convertible notes are great.

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They make our lives much easier – we don’t have to negotiate with founders over onerous deal terms that normally exist in an equity round (e.g., liquidation preferences, board seats, protective provisions, etc.) or go back and forth with their lawyers, a mentally draining process that rarely feels productive.

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With limited legal due diligence to conduct, VCs simply need to negotiate the valuation cap and/or discount rate – two terms, which over the last couple of years, were set by the market anyway (20%-25% dilution and a 20% discount rate), leaving negligible effort on the investors’ end to close a deal. 

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At best, some VCs will go the extra mile to negotiate a Most Favored Nation clause, information rights and/or pro-rata rights – rights which actually sit outside the convertible note and in a side letter.

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Founders tend to prefer convertibles too. Historically, they have been sold as a quick, cheap, and easy way to close a round; convertibles incur low legal fees, don’t require all investors to consent to the same terms or close at the same time, and they “kick the valuation discussion down the road” (a popular yet nebulous saying in the VC/startup ecosystem).

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Most importantly, convertibles are templated documents that are simple to read and understand, especially for founders who may have limited experience with legal documentation. SAFEs, the most popular type of convertible, which originated from YCombinator, are at most five-pages long. 

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For these reasons, convertibles, and namely SAFEs, are the dominant choice for founders and investors alike for pre-seed, seed, and bridge rounds.

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How convertibles work

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At a very high level, convertibles are relatively easy to understand - an investor provides capital today with a promise that it will convert into equity tomorrow at a predetermined price. It is most akin to buying an option contract in a publicly traded company. 

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The conversion price is the most important aspect of a convertible note (i.e., the price per share at which the convertible note converts into equity). This price is either calculated as:

1. the price per share equal to the valuation cap divided by the number of outstanding shares pre-round (valuation cap / outstanding shares pre-round) or
2. the price per share of the subsequent equity round multiplied by one minus the discount rate (price per share of next equity round x (1 – discount rate))

Investors have the right to choose between the above calculations and select the one which results in a lower price per share (or a greater number of shares) in the company, allowing them to maximize their equity and get the best deal possible, no matter the terms of the future equity round.

In most cases, this means that if the subsequent equity round is an:

• Up-round (pre-money valuation of the next equity round is higher than the valuation cap of the convertible), then the investor converts at the valuation cap (thus capturing the upside) 
• Down-round (pre-money valuation of the next equity round is lower than the valuation cap of the convertible), then the investor converts at the discount rate (thus receiving downside protection) 

The common misunderstanding between founders and investors

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While the above may seem relatively straightforward and looks to leave very little wiggle room for misinterpretation – in our experience, at the time of conversion (i.e., at the next equity round), founders and investors are often misaligned about each other’s ownership. In many cases, founders are taken aback by how much equity they have given away.

Given that founder ownership is a very sensitive issue, this leads to awkward conversations between founders and investors, especially when a founder believes that they had significantly more ownership than they are left with. This situation isn’t ideal for VCs either; we need the founders we invest in to be incentivized to succeed as our future profits depend on their continued dedication to the business.

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The main reason behind the misunderstanding, in our experience, is that while a standard convertible note outlines the conversion price well (conversion at valuation cap or discount rate), it does not address a very important issue – the order in which the convertibles convert. Because this is not specifically outlined in the convertible note, it is often not discussed between founders and investors, creating a potential issue down the line.

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Why the order of a convertible’s conversion matters

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While the order of conversion may seem like a small nuance in the grand scheme of things, it significantly impacts the math behind calculating the conversion price, ultimately affecting each shareholder’s ownership. Its effect is meaningfully compounded if a company raises many convertibles in a row, without an equity round in between to convert them, which has become common practice over the last few of years as founders look to focus on building in the early-stages and delay their first formal equity round.

Put simply, pre-money convertible notes can either convert a) all at once or b) sequentially. 

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All at once:

• If multiple convertible notes convert all at once, the first convertible note converts into equity at the same time as the second convertible note (time of conversion of first convertible note is equal to time of conversion of second convertible note)
• Since they convert into equity at the same time, the number of outstanding shares pre-round is the same for all noteholders and does not include the number of shares issued to the noteholder who came in first chronologically.

Sequentially:

• If multiple convertible notes convert sequentially, the first convertible note converts into equity before the second convertible note (time of conversion of first convertible note is not equal to and is before the time of conversion of second convertible note)
• Since they do not convert into equity at the same time, the number of outstanding shares pre-round is not the same for all noteholders and does include the number of shares issued to the noteholder who came in first chronologically.

Why is this important?

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A convertible will convert into equity at either the valuation cap or the discount rate, depending on which calculation yields a lower price per share. Since the number of outstanding shares pre-round is an important variable for this calculation (see calculations 1 and 2 in ‘How convertibles work’), it impacts the conversion price per share and the overall conversion mechanics, and as such, shareholder ownership.

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To make this clearer, let’s take a hypothetical scenario with the following assumptions:

• Startup X was formed in 2020 by two founders
• At company formation (i.e., the founding round), the founders were issued 1,000,000 ordinary shares together, which represented 100.0% ownership of the company at that time (no other shareholders existed)
• Over the course of the last three years, the company raised a total of $6.75m across five convertible note rounds at various pre-money valuation caps ($2.0m – $22.0m pre-money), each with a 20.0% discount rate (see table below)
• The company is currently in the process of raising their first equity round, which is a $20.0m Series A at a $60.0m pre-money valuation

Let’s deep dive into how the cap table would look under both conversion scenarios:

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1. Scenario 1: all at once conversion 

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If the outstanding convertible notes were to convert all at once at the Series A equity round, then investors in the Seed-1, Seed-2, Seed-3, Seed-4, and Seed-5 convertible note rounds would convert at the same time. This means that the total share count of the company pre-round would be equal for all investors (Seed-1 investors have the same outstanding shares pre-round as Seed-2, Seed-3, Seed-4, and Seed-5 investors).

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In this case, the equation to calculate the conversion price at the valuation cap would be the pre-money valuation cap of each round divided by the fixed number of outstanding shares post the last equity round. In our example, this is 1,000,000 shares outstanding for all investors. 

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For example, the valuation cap price per share for:

• Seed-3 investors would convert at the $9,000,000 pre-money valuation cap divided by a fixed 1,000,000 shares outstanding at the founding round (last equity round) = $9.00 PPS
• Seed-4 investors would convert at the $16,500,000 pre-money valuation cap divided by a fixed 1,000,000 shares outstanding at the founding round (last equity round) = $16.50 PPS.

‍2. Scenario 2: sequential conversion 

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If the outstanding convertible notes were to convert sequentially at the Series A equity round, then the investors’ convertible notes would convert in chronological order (i.e., Seed-1 investors would convert first, then Seed-2 investors, then Seed-3 investors, and so on). This means that the total share count of the company pre-round would not be equal for all investors (the number of shares outstanding pre-round for Seed-2 investors would include the number of shares issued to investors in the Seed-1 round, the number of shares outstanding pre-round for Seed-3 investors would include the number of shares issued to investors in the Seed-1 and Seed-2 round, and so on).

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In this case, the equation to calculate the conversion price at the valuation cap would be the pre-money valuation cap of each round, divided by the fixed number of outstanding shares post the last equity round in addition to the shares issued by previous convertible note rounds. 

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For example, the valuation cap price per share for:

• Seed-3 investors would be the $9,000,000 pre-money valuation cap divided by 1,470,558 shares outstanding (1,000,000 shares outstanding at the founding round + 250,000 shares for Seed-1 investors + 220,558 shares for Seed-2 investors) = $6.12 PPS
• Seed-4 investors would be the $16,500,000 pre-money valuation cap divided by 1,633,987 shares outstanding (1,000,000 shares outstanding at the founding round + 250,000 shares for Seed-1 investors + 220,558 shares for Seed-2 investors + 163,399 shares for Seed-3 investors) = $10.10 PPS

Why does this matter?

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The ownership delta between the two conversion scenarios is striking.

• In Scenario 1, the founders will own 42.50% of the company post the Series A round if the convertible notes convert all at once. 
• In Scenario 2, the founders will own 37.03% of the company if the convertible notes convert sequentially

This equates to 5.47% less ownership of the overall company and 12.87% less ownership personally. 

At a post-money valuation of $80.0M at the Series A round, the founders have lost $4.38m in equity value that they would have gained if the conversion was all at once.

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Another interesting observation is that the gain by other (non-Series A) investors if a sequential method is used is not equal – the latest convertible investors gain the most (they get diluted the least). In this case, those are the Seed-5 investors, who gain 55.31% extra ownership via using the sequential method due to the lower dilution impact. 

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Series A investors always get the same level of ownership in either case since the convertibles convert before Series A investors enter the company. 

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What does this cause?

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As you can see, this can cause a large misalignment of incentives – founders may want to use one conversion method, while investors may want to use another. This can create serious conflicts.

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To complicate matters further, whether an investor prefers an all-at-once or sequential conversion method depends on how early they invested in the business, and what their blended entry price-per-share is. Given that VCs often follow-on in their portfolio companies, and all enter at different stages (depending on their investment mandate and sweet spot in terms of stage), each VC has different incentives around which conversion method to use.

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In the hypothetical scenario below, the founders and Investors 1-8 prefer the all-at-once method, while Investors 9-19 prefer the sequential method. Investors 20-22 don’t care because they are only investing in the Series A equity round, which are unaffected by the convertible round.

This puts the founders in an uncomfortable position – which method do they choose, and how do they decide who is better off (i.e., who gains the most)? You can make a case for every party:

• The founders should only care about themselves and do what’s best for them
• The founders should please their oldest investors, who took the most risk and backed them from day 1 with their first cheque 
• The founders should please their newest investors, who have invested the largest amount of capital and are most probably also participating in the current Series A equity round

As you can see, it can get messy – between the founder and investors, and between investors themselves. In the end, it comes down to a compromise, but do founders really want to set themselves up with a situation down the line where they can’t please everyone? 

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Nuwa’s recommendation to founders looking to avoid this situation is to set the conversion method early on before the first convertible round is raised. Founders should also always have a pro-forma cap table on hand that clearly defines the order in which convertible notes convert. That way, there is no confusion and no future grounds for dispute. 

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Are post-money SAFEs they the solution?

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A few years ago, YCombinator refreshed its SAFE note template from a pre-money basis to a post-money basis.

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One of the biggest advantages of the change was that, with the new structure, investors had complete clarity over the ownership they gained after investing in a startup. For example, if an investor invested $1.0m in a startup at a $10.0m post-money valuation cap, the investor would own 10.0% of the company today ($1.0m investment amount / $10.0m post-money valuation cap = 10.0%) before the next equity round (assuming conversion at the valuation cap).

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With this new instrument method, the order of conversion didn’t matter anymore – it became abundantly clear how much each investor owned in the business (by doing the above calculation). All seemed to be fixed.

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However, this method has important negative ramifications for founders: every incremental dollar raised via a post-money SAFE only dilutes the existing equity shareholders and not any other post-money SAFE co-investor. 

What this means, in practice, is that if founders (who are the only existing equity shareholders at a company’s inception) stack multiple post-money SAFE notes or rounds (like above) before raising an equity round, they are the only ones being diluted (i.e., no other convertible investor is sharing the dilution). This is not the case in the pre-money method outlined above, where SAFE convertible investors share this dilution hit (in most scenarios). 

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What does this mean for ownership?

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Using the same hypothetical scenario above, instead of founders owning:

1. 42.50% of the company if the SAFE was on a pre-money basis and converted all at once or
2. 37.03% of the company if the SAFE was on a pre-money basis and converted sequentially,

‍The founders would only own 26.00% of the company if the SAFE was on a post-money basis. 

This equates to:

• 16.50% less ownership of the overall company vs. the all at once pre-money method of conversion
• 11.03% less ownership of the overall company and the sequential pre-money method of conversion

At a post-money valuation of $80.0m at the Series A round, the founders have lost:

• $13.2m in equity value that they would have gained if the conversion was all at once or
• $8.8m in equity value that they would have gained if the conversion was sequential

While solving for this confusion, post-money SAFEs are significantly worse-off for founders.

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Final takeaways

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As we can see from the examples above, while it may seem like a minor detail, the type of SAFE (pre-money vs. post-money) and the order of conversion (all at once or sequentially) can really impact founders’ ownership and their equity value if not discussed or modeled out beforehand.

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In a world where founders have the ability to stack multiple SAFEs on top of each other quickly and easily, this ownership impact can really add up, even if the SAFEs are raised at rolling, higher valuation caps.

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With the above, we hope founders have a deepened level of understanding around the intricacies of convertible notes and use this information to their advantage when negotiating with investors.

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Arnav Danthi is Principal at Nuwa Capital