The truth about convertible notes at exit
Kristian Holte, attorney | kh@edisonlaw.dk
You have raised money on convertible notes. Maybe through several rounds.
If you are like other founders, you would be interested in knowing:
- What actually happens with convertible notes when you sell your company
- What the conversion means financially for you and your investors
- What consequence terms like caps and liquidation preferences have
This post gives you the tools to understand what an offer to buy your company would mean when you’ve already raised money on convertible notes.
What price does investor pay when converting the note into shares?
The answer to this question determines how much of the company the investor will end up owning after converting the note into shares.There are different ways of setting the conversion price in of case of exit. One way is to set the price based on the price paid by the buyer. Based on that price, investor then typically gets a discount, of say 20%.
The relevant language in the convertible note could be formulated as follows:
In this way investor profits from the exit because of the discount.If conversion takes place in connection with an M&A Event, the price shall be set as the price offered in the M&A Event with a discount of 20%.
It is useful to contemplate relevant scenarios in order to know how a given purchase offer will affect existing convertible notes at exit. I recommend figuring out the different scenarios in an excel sheet or the like.
Simulate probable exit-scenarios
Let us illustrate with an example:- Two founders each own 40%
- Investor I owns 20%, which Investor I has paid DKK 20 million for at a post-money valuation of DKK 100 million
- Investor II has invested DKK 10 million through a convertible note which allows Investor II to convert the note with 25% discount in case of exit with no cap
- Both investors have so-called 1x participating liquidation preferences
- 100,000 shares have been issued in the company before the conversion
- Three potential buyers have made offers of DKK 50, 150 and 500 million respectively
- Investor II elects to convert the note in each scenario
How will the purchase price from the sale be allocated in each scenario?
#1 – Exit at DKK 50 million
Investor I receives ≈ DKK 23,157,910
- Owns 20,000 shares = 15.78% of the company
- Receives DKK 20 million in liquidation preference, plus
- DKK 3,157,910 corresponding to 15.78% of DKK 20,000,000
Investor II receives ≈ DKK 14,210,440
- Owns 26,666 shares after conversion = 21.05% of the company
- Receives DKK 10 million in liquidation preference, plus
- DKK 4,210,440 corresponding to 21.05% of DKK 20,000,000
The two founders receive a total of ≈ DKK 12,631,640, i.e. each ≈ DKK 6,315,820
- The founders own a total of 80,000 shares = 63.15% of the company
- The founders receive a total of ≈ DKK 12,631,640 corresponding to 63.15% of 20,000,000
#2 – Exit at DKK 150 million
Investor I receives ≈ DKK 42,044,090
- Owns 20,000 shares = 18.36% of the company
- Receives DKK 20 million in liquidation preference, plus
- DKK 22,044,090 corresponding to 18.36% of DKK 120 million
Investor II receives ≈ DKK 19,795,010
- Owns 8,888 shares after conversion = 8.16% of the company
- Receives DKK 10 million in liquidation preference, plus
- DKK 9,795,010 corresponding to 8.16% of DKK 120 million
The two founders receive a total of DKK 88,163,980, i.e each ≈ DKK 44,081,990
- The founders own a total of 80,000 shares = 73.46% of the company
- The founders receive a total of DKK 88,163,980 corresponding to 73.46% of DKK 120 million
#3 – Exit at DKK 500 million
Investor I receives ≈ DKK 111,559,030
- Owns 20,000 shares = 19.48% of the company
- Receives DKK 20 million in liquidation preference, plus
- DKK 91,559,030 corresponding to 19,48% of DKK 470 million
Investor II receives ≈ DKK 22,204,810
- Owns 2,666 shares after conversion = 2.59% of the company
- Receives DKK 10 million in liquidation preference, plus
- DKK 12,204,810 corresponding to 2.59% of DKK 470 million
The two founders receive a total DKK 366,236,140, i.e. each ≈ DKK 183,118,070
- The founders own a total of 80,000 shares = 77.92% of the company
- The founders receive a total of DKK 366,236,140 corresponding to 77.92% of DKK 470 million
Lesson #1
As shown, the founders have virtually no economic interest in a “low-exit” as founders’ share of the purchase price is mostly consumed by the investors’ liquidation preferences.Lesson #2
As the buyers’ bids increase, it is worth noting that Investor II pays a higher and higher price per share at conversion.This is the case because Investor II did not negotiate a “cap” which effectively would have set a ceiling on the price Investor II might have to pay.
In our scenario, Investor II probably would have been proportionally better off having completed the initial investment as a direct equity investment at a fixed valuation.
Lesson #3
The calculations show how important it is to work with realistic economic scenarios when raising capital through convertible notes. In this way it is possible to get a grasp of the potential impact of different terms. This applies from initial term-sheet all the way to exit.
Kristian Holte, attorney | kh@edisonlaw.dk