Are convertible notes pre-money?

How should I account for convertible notes of a company before I invest?

Convertible notes aren’t new; they’ve been around for over 15 years, mutating from their original form as bridge notes used by VCs to provide short-term capital to a company while a financing deal was pending.

But people still get confused when it comes to thinking through the mechanics of the conversion event. There isn’t a standard approach built into the documents, primarily because the party who cares isn’t at the table.

Investors ask whether prior convertible notes dilute their investment:

How is it that I invest 150k, but post money, my shares are worth only 149k?

The short answer is that as the investor coming in with new cash, your investment should always be worth the same amount. Because many startups are without skilled or experienced startup counsel (which includes the ability to create a formula-driven excel spreadsheet to calculate the capitalization numbers), there are many companies seeking early money with (1) complicated overuse of convertible notes and (2) no real understanding of what fully diluted capitalization means.

To give the new investor the benefit of the bargain, something in the note conversion calculation has to change – it’s just math. What changes to get to that result is either:
– the effective pre-money valuation goes down, or
– the pre-money capitalization goes up.

An investor would identify this kind of value dilution at closing by looking at a pro forma cap table: the $150k represents a smaller percentage of the post-money that would be expected based on a true pre-money valuation and true pre-money fully diluted capitalization. As an example, if the pre-money valuation based on a fully diluted cap is $1,350,000, an investor writing a $150k check would expect to end up with 10% of the company afterwards.

(You did look at the pro forma cap table, right? If you’re looking at the actual post-money cap at this point, it’s either unfixable or messy.)

Representing investors coming in on a cash basis when there are prior notes, I typically expect that the post-money will look like what I expect: last money in makes the rules and then either the deal works for everyone or it doesn’t. When I make the cap table, I put the note dilution into the pre-money so that it’s borne by the existing holders – MY investor client didn’t sign up to give those people a deal; they negotiated it with the old holders so it properly belongs in the pre-money.

Some people make the point that notes aren’t “technically” in the pre-money, and they’re only sort of right: convertible notes wouldn’t likely be on a cap table reflecting outstanding equity, but they absolutely should be on a cap table prepared on a fully diluted basis, like options, warrants, and any other similar rights. That’s what “fully diluted” means – once a company starts to carve anything out of that, two things happen: it is being misleading – which might be fraudulent, and it starts down a slippery slope of structuring transactions in ways that are hidden by that misleading cap table, exacerbating the problem.

If you’re already in the middle of an investment where this problem exists, call a lawyer who gets it. Investors taking the self-help route typically start by reviewing the cap tables provided by the company as well as the capitalization rep in the deal documents. These two items:
1. contain the facts needed to analyze the situations
2. are the first places a problem is likely to be spotted
3. are places where a path to a remedy commonly presents itself.