From Seed Convertible Note to Series A Round – The Real Impact for Startups’ Founders
Many startups at the seed stage raise capital from private investors and issue convertible notes or notes known as ‘SAFE’ (Simple Agreement for Future Equity). At this stage, their cap table is still relatively simple, and includes exclusively common shares and perhaps a few options granted to key employees.
The problem for companies’ post-money Series A cap tables, however, is that it is assumed that all Series A share classes have similar financial terms and value. In this post, we’ll explain how to determine the true economic value of each Series A share class, and their impact for existing shareholders.
The majority of a company’s convertible note terms can be summarized into two distinct scenarios.
Scenario 1: The company succeeds in raising capital within a defined period of time, and the convertible note (including interest) is automatically converted into the securities of the next round financing (Series A), with a discount or with a cap on the company’s post-money valuation.
Scenario 2: The company does not succeed in raising capital within a defined period of time, and the convertible note is automatically converted into common shares based on a conversion price defined as of the issuance date of the convertible note.
Based on recent market data, the majority of deal terms for pre-Series A convertible notes are (source: “The Entrepreneurs Report, 2015”, Wilson Sonsini Goodrich & Rosati):
Let’s look at an example (scenario 1): Suppose that a private company is currently raising $3 million in a Series A round. Prior to the round, the company has issued common shares to the founders and a convertible note to private investors. The pre-Series A cap table and the deal terms of the convertible note are:
Step 1: The parties negotiate the percentage to be given to the new investors, in exchange for $3 million invested in the company (participating preferred stock subject to a 2x cap). In this example, we assume that they’ve agreed on a 25% stake. A term sheet is being negotiated.
Step 2: The new cap table is created based on the following: $3 million divided by a 25% equity stake in the company on a fully diluted basis, resulting in a post-money valuation of $12 million ($3 million/25%). This reflects the ownership structure, but does not consider actual economic returns.
Step 3: The investors and the company agreed to issue an unallocated Employee Stock Ownership Plan (ESOP), with an exercise price of $1 per share, representing 10% of the company’s equity on a fully diluted basis.
What then will be the round A financing – post money cap table of the company?
The Problem: This overly simplistic presentation of the company’s post-money Series A cap table assumes that all Series A share classes (issued at round A and from the convertible note) have similar financial terms and value. Based on feedback received from several company founders, the confusion is due to the fact that they have the same seniority level in terms of liquidation preferences (Pari-Passu). The fact is that there is another share class that take ownership percentage and value from the founders and the option holders.
What then is the true economic value of each Series A share classes, and the impact for existing shareholders?
1.) Each of the preferred A share classes has a different issue price: $31.50 for each Series A share issued at the financing round to investors, vs. $10.50 for each Series A share from the convertible note – representing a difference of 67%.
2.) Each Series A share class will convert into common shares at a different company value and will get a different payoff, even though they are in Pari-Passu. Therefore, the economic fair value of the Series A shares issued to investors and of the convertible note will be different.
In this example, Series A will reach their participation limit of the 2x cap at a company value of $14.962 million, and will convert into common shares at a company value of $23.962 million. Series A shares from the convertible note will reach their participation limit of the 2x cap at a company value of $7.462 million, and will convert into common shares at a company value of $10.962 million.
Below are waterfall graphs generated from AlgoValue, illustrating the true economic value of these shares.
This is the ’Start-Up Ecosystem’, a place where stakeholders are not sufficiently aware of and frequently not well-advised about the complex and varied nuances of valuation-related issues. As you can see from the example above, the company already has a complex capital structure with three different share classes (Series A, Series A from the convertible note, and common shares), as well as stock options. In the example above, we demonstrated how a convertible debt can take a significant ownership percentage and future value from the founders and the option holders.
This is where AlgoValue can help. AlgoValue helps startups and investors maximize their negotiations, and become better prepared to handle the challenges that come with capital raising today.