Having a relatively small about of convertible debt on your balance sheet prior to your Series A financing is not a bad thing.  I am a big fan of convertible debt (with appropriate terms).   Typically the convertible debt automatically converts in a Series A round of at least $X within Y time frame.  So $X might be at least $1mm and Y time frame might be within 18 months of the convertible debt issuance.  The X and Y are negotiated, with the Y typically being a date shortly before the convertible debt is all used up by the company in its operations.

One interesting point that comes up a lot is how to factor the convertible debt into the premoney valuation of the Series A round.  Let’s assume the following:

• Common Stock outstanding:  3,400,000 shares owned by the founders.
• Option pool:  500,000 shares (some issued, some reserved, but that is typically irrelevant as the whole pool is normally factored into the premoney share price calculation)
• $62,000 of convertible debt outstanding with $13,700 of aggregate interest accumulated, which also converts as well in the qualifying round.  And let’s assume that the debt has a 20% conversion discount.  I am going to ignore any valuation cap feature.
• Series A premoney valuation negotiated to be $3mm.

So, to calculate the Series A share price, you take the premoney valuation of $3mm and divide it by the number of premoney shares, which again will typically include the whole option pool.  So, $3mm/(3,400,000+500,000) = $.7692 per share.   That would be the share price of the Series A stock being sold to new Series A investors.

But, what about the convertible debt?  The convertible debt has what I like to call “purchase power” equal to ($62,000+$13,700)/(1-20%)= $94,625.  That is how much Series A stock will be issued to the debt holders.

If you don’t factor this purchase power into the premoney valuation, the Series A new investors are going to end up with less than what they expect.  In our example, if the premoney is $3mm and the Series A new investors are putting in $1mm, then they expect to own 25% of the company after the closing ($1mm invested/$4mm post money).  But, when you factor in the convertible debt purchase power, the post money valuation is actually $4,094,625 (just $3mm premoney plus $ amount of Series A sold).  So the new Series A investors end up with 24.4% ($1mm/$4,094,625).   Granted, that is not much dilution, BUT what if there were like $600K of convertible debt instead of $62K.  Ouch, then the dilution is real.

The easiest way to deal with this issue (and the way I like to deal with it), is to simply subtract the convertible debt purchase power from the negotiated premoney valuation.  So, in our example, the new premoney valuation would be $3mm minus $94,625 = $2,905,375; the new Series A share price would be $2,905,375/(3,400,000+500,000) = $.7450 per share (note how it is lower than the per share price calculated above).   And the post money would be $2,905,375 + $1,094,625 (which is the total Series A sold including the convertible debt) = $4mm.  And, viola, the new Series A investors who put in the fresh $1mm own 25% post money.

The one big issue to keep at the front of your mind is that the more convertible debt you have on your balance sheet prior to the Series A round the bigger the impact on the “true” premoney valuation (in the downward direction).   It can get painful so make sure to manage your expectations.