# Don't Let the Funky Math of Convertibles Bite You

By [Continuations](https://continuations.com) · 2009-11-06

financing, series a, convertible debt

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Convertible notes tend to be a great way to raise money from angels.  They are easy to paper and don’t lock in a valuation or terms.  But they will impact the valuation of the financing that they convert into and in a way that’s a bit funky.  
  
The math of an investment when there is no converting debt is simple.  For the company as a whole it goes: Pre money valuation + total amount raised = post money valuation.  Ownership for each investor is determined as amount invested / post money valuation.  Consider a Series A financing of $3 million total on a $7 million pre.  The post-money is $7 million + $3 million = $10 million and an investor who puts in $2 million owns $2/$10 = 20%.  
  
Now let’s put a $1 million convertible note into the picture.  Let’s assume that it converts at either a 20% discount or a maximum valuation of $4 million pre (this is a “capped” convertible).  Now the math for the $3 million Series A gets considerably funkier.   Let’s again assume a that the pre-money is $7 million.   A 20% discount on that is $1.4 million which gets you down to $5.6 million which is above the $4 million cap for the convertible.  So the convertible will convert at the $4 million cap.  
  
What does that do to the Series A?  Let’s for a moment assume that the company starts out with 4 million shares.  Then the per-share price paid by the note holders will simply be $4 million pre / 4 million shares = $1/share.  On the other hand the Series A will pay $7 million pre / 4 million shares = $1.75/share.  The note  holders will wind up buying 1 million shares and the Series A in total $3 million / $1.75/share = 1,714,285 shares.  So after the financing is done, there will be 4 million + 1 million + 1,714,285 shares = 6,714,285 shares outstanding.  So what does someone who puts in $2 million into the Series A own now?  $2 million buys $2 million / $1.75/share = 1,142,857 shares and thus 1,142,857 shares / 6,714,285 shares = 17%.  
  
So that’s quite a bit less than the 20% without the convertible.  In fact, we can figure out what the effective (or implied) post-money valuation is.  $2 million / x = 17%, so x = $11.76 million.   Compare that to the previous post-money valuation of $10 million and you notice that the deal has gotten 17.6% more expensive for the new investors because of the convertible!

P.S.  I wrote this post on the train this morning not knowing that Fred had posted about how the [size of the option pool is tied directly to valuation](http://www.avc.com/a_vc/2009/11/valuation-and-option-pool.html) as well. It is easy for a deal to be effectively much more expensive than “the sticker.”

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*Originally published on [Continuations](https://continuations.com/dont-let-the-funky-math-of-convertibles-bite-you)*