Discount or cap? A spreadsheet that shows what happens when a note converts.
Venture math can be tough. Terms like convertible note, discount and cap can complicate a seemingly easy process. A convertible note is a debt instrument typically used when a company first begins to raise capital. The valuation of the company is determined at a later date, after a Series A investment. This is when a note converts to equity at the previously agreed upon terms. A discount and cap are typically included in those terms. A discount gives a note holder’s small investment a little bit more purchasing power. But with a discount, there is no limit to the valuation of the company. That’s where the cap comes into play. A cap limits the valuation of the company to a pre-determined price. In other words, it protects early investors (note holders) from being diluted to oblivion. Owning 0.0004% of a company sucks for someone who took most of the risk, and a cap prevents that from happening.
While often spoken in the same sentence, a cap and discount are never used at the same time. They are mutually exclusive. When a note converts, the more generous of the two options is used. That depends on what the valuation of the company is, and the amount being raised in the Series A, among other things.
The terms of a note can vary dramatically, but the most common include a $3m cap, 20% discount and 8% interest. So, how much does the team own after the Series A (when the note converts)? It’s tricky to figure that out, so I put together the attached spreadsheet to help.
How it works
In this spreadsheet, a note holder converts using whichever of the cap or discount results in a lower share price. But calculating a share price is tricky. This spreadsheet will help take you to the promised land.
For me, the key to calculating share price was learning what “effective valuation” means. ”Effective valuation” is sort of like the “enterprise value”, commonly used when talking about publicly traded companies.
Enterprise Value = Market Cap + Debt - Cash
The enterprise value is the amount an acquirer would pay for a company. In this exercise the enterprise value is the “valuation”. But the market cap is what’s used to calculate share price, so we have to solve for it. Assuming there is no cash on the balance sheet, we solve for market cap by subtracting the debt from the enterprise value. The market value of debt depends on if the discount or cap is being used, therefore it’s the “effective valuation”.
Once you have the effective valuation, you can calculate the share price for the Series A investor, and then adjust the share price for the note holder. Click into each cell to study the formula used - it makes more sense visually.
Random notes regarding the spreadsheet
The spreadsheet provides a visual for what has been explained by many others, on many different sites (I learn easier this way). It can be a good resource to send to family/friends participating in early rounds. However, there are easier ways to relay the information. For example, using back of the envelope math, you can figure the cap table out without a number of shares (see the rows labeled “equity” for the formula).
So, take the spreadsheet with a grain of salt (I’ll post updated versions here, if necessary). The spreadsheet is not a suggestion on how to do your fundraise, and it’s certainly not legal guidance. It’s just another helpful resource (hopefully), among many.
Edit: Most Series A investors will want to create an option pool. There is now a second worksheet in this updated document that shows the effect of creating an option pool. This is version 1.1.
Edit (12/4/2012): There was a small reference error in the spreadsheet that has been resolved in this version.