How to Review Convertible Notes
Let’s talk about convertible notes, especially in the context of angel investing, venture capital, and other early-stage startup investments.
What are convertible notes?
Convertible notes are investments that start as debt and then convert to equity. The conversion is subject to terms and conditions described in the legal language of the convertible note.
Many investors assume that the legal language found in convertible notes is always standard, and thus not something for them to worry much about. But that is not the case. The legal language in convertible notes can vary widely, and often to the detriment of you, the casual investor dabbling in startups.
Specifically, I am focused in this article on the section of the convertible note that defines the formula for calculating how many shares the investor receives when the note converts from debt to equity. Unfortunately, in many deals, this formula is a disaster for the unknowing investor.
How Do convertible notes convert from debt to equity?
Convertible notes convert from debt to equity in accordance with a seemingly simple calculation. The calculation has three main steps:
The calculation begins with the amount of money invested, which starts out as debt, and you add any interest that accrued prior to the conversion. With the original investment plus any interest, you have the total amount of debt that will convert to equity.
Next, once you have the total amount of debt, the next step is to find out what percentage of the company that debt represents. For example, if you have $500,000 of convertible debt invested in a startup, and the agreed valuation of the startup is $5,000,000, then your debt should convert to a number of shares worth 10% of the company.
In the final step of the calculation, you take the percentage that you reached by dividing your total debt over the presumed valuation of the company (i.e., $500,000 / $5,000,000 = 10%), and you multiply the percentage by the total number of shares. In the example above, if the company has 1,000,000 total outstanding shares, then the investor whose debt represents 10% of the value of the company should receive 100,000 shares.
It may seem like a simple and uncontroversial calculation, but there’s a dangerous twist.
The Problem With Converting from Debt to Equity
A key issue, with respect to how a convertible note defines the total number of shares for purposes of conversion, is whether the definition includes shares represented by an options plan or a vesting-type arrangement like a stock option plan or other equity compensation plan.
The Existence of Unvested Shares
In these arrangements, a founder, employee, or another investor will often receive full ownership of certain stock only after a certain period of time has passed or other conditions have been met.
Once the conditional shares have been vested in (and/or exercised by) the founder, employee, or other investor, that person’s shares will instantly dilute your shares. Therefore, you need to make sure that those conditional shares, which may become fully owned shares, are counted in the calculation when your note converts from debt to equity.
The Effect of Unvested Shares
In the example above, where the company had 1,000,000 shares outstanding, assume 200,000 of those shares are set aside as equity compensation for founders and key employees. While those set aside shares are not technically outstanding, the shares are also not exactly property of the company either, since the company will need to hand those shares over to the founders and employees once the shares are vested (and/or exercised).
If the 200,000 shares that were set to vest in founders and employees were not counted as outstanding shares in your conversion calculation, then your conversion calculation would have been 10% of 800,000 “total outstanding shares” rather than 10% of 1,000,000 true total outstanding shares.
Bottom line:
Unfortunately, when you know that the true number of total outstanding shares is actually 1,000,000 not 800,000, you learn that you have been diluted by the founders and employees. You have essentially received 80,000 shares out of 1,000,000 total outstanding shares -- not 80,000 out of 800,000 total shares.
Therefore, in the example above, you only own 8% of the company instead of the 10% that you thought you bargained for. Your investment dropped 20% ($100,000) the moment you signed a convertible note without checking the mechanics of the conversion calculation.
Adam Yohanan represents entrepreneurs, investors, freelancers, startups, small businesses, artists, and entertainers in a wide variety of transactional and regulatory matters, with an emphasis on complex commercial contracts, business formations, corporate governance, M&A, finance, intellectual property, and entertainment law. His office can be reached at 212-859-5041.
