Over the past few days there have been 2 important blog posts on convertible debt.  The first was Mark Suster’s post titled “One Simple Paragraph Every Entrepreneur Should Add to Their Convertible Notes” and the second was Brad Feld’s post titled “The Pre-Money vs. Post-Money Confusion with Convertible Notes“.

Mark’s post warned of the often unintentional punishment that founders inflict on themselves when doing a convertible debt deal that contains a valuation cap.  The punishment comes in the form of “unjust” liquidation preference that the note holders end up with when they convert at a valuation cap that is way lower than the valuation of the actual round.  Quick explanation:  a note with a valuation cap provides that upon a subsequent conversion of the note to equity resulting from a subsequent equity round (let’s say a Series A round), the note holder either converts at a price equal to (i) a stated discount to the Series A price OR (ii) a price determined using the valuation cap.  For example, if the valuation cap was $3mm and the Series A round pre-money valuation was $10mm, then it would be likely that the note holders conversion price would be determined using the valuation cap (so $3mm/# of shares outstanding fully diluted pre-money = conversion price).   Bottom line:  the note holder chooses whichever option gives a lower price for conversion.

The “unjust” liquidation preference comes in when the valuation cap price applies (it also applies a bit with a discount that is large).  In the example above, let’s just pick easy numbers and say the Series A price is $1.00 per share (calculated by taking $10mm premoney valuation/10mm shares outstanding fully diluted = $1.00).  Appling the valuation cap of $3mm, the conversion price would be $3mm/10mm shares outstanding fully diluted = $.30.  So the note holders convert their principal and accrued interest at $.30 a share and buy a lot of Series A!!!  Each share of Series A will have a liquidation preference of $1.00 (assuming 1X preference, which is normal).  So, the note holders pay $.30 a share yet get $1.00 per share liquidation preference.  WOW!!  Therein lies the “unjust” liquidation preference of $.70 a share!!  It is like unjust enrichment.   You can read Mark’s post on how to solve this problem.

Brad’s post talks about how convertible debt factors into the premoney valuation……or NOT.  My view on this is clear:  the purchasing power of the convertible debt (which in simplest terms equals (i) the number of shares purchased by the convertible debt AFTER applying discounts or valuation caps, multiplied by (ii) the full price of the shares paid by new purchasers) needs to be subtracted from the negotiated premoney valuation.  If it is not subtracted then the new equity purchasers are not getting what they bargained for.  I wrote a detailed post on this issue called “Building Convertible Debt Into the Premoney Valuation” back in early 2013.  If you want a good explanation, check out this previous post.

Thanks!