Question

Jonna Vella, Inc. is raising $250,000 in early stage money to fund development of their prototype. The company is still in a very early stage, and doesn't feel ready to put a valuation on themselves. So they are raising this round as a convertible debt round with the following parameters: the debt will convert to equity on the first priced round, at the valuation of the firm in that priced round, plus a 20% bonus. The debt will earn 5% per year until conversion. Suppose that the company raises $1 million in a priced round in one year, and that the round values the company at $10 million.

How much will the debt be worth (in dollars) at the time of conversion?

What % ownership of the company will that represent, at the time of conversion?

What % ownership of the company will the new investors want to own for their $1 million?

If the founders own 100,000 shares, how many shares will the new investors receive?

How many shares will the convertible debt holders receive at conversion?

Make a simple table to show the shares owned, and corresponding % ownership, by each of the three groups (founders, convertible debt investors, equity investors) after conversion.

Suppose that the convertible debt investors try to negotiate a larger "bonus" of 25% to their investment (so they would receive an extra 25% share of the company instead of 20%). Who would benefit from this, and who would lose?

Suppose that the convertible debt investors negotiate a valuation "cap" of $5 million. This means that their debt would convert as if the company were worth no more than $5 million, regardless of the valuation from the priced round. Who wins and loses with this valuation cap?

Explain each question

Answer 1

Case 1
The debt will have a 20% bonus at the time of conversion. Hence, the value of the debt will be 1.2 times the original value. Note that the 5% coupon earned on the debt will not be considered at this time of valuation since this is the fixed portion and settled in cash.

value of debt in beginning	250,000
bonus multiple	1.2
value of debt in conversion	300,000	=250,000*1.2

The post money valuation of the company is $10Mn. The ownership structure is as follows-

Group	$ value of ownership	% ownership	no of shares	per share price
1st round funding investor	1,000,000	10.0%	11,494	87.00
Convertible debt holder	300,000	3.0%	3,448	87.00
Promoter / founder	8,700,000	87.0%	100,000	87.00
Total	10,000,000	100.0%	114,943	87.00

Per share price will be same for all the investors since there is not mention of differential share price. The per share price for all investors will be based on the per share price of promoters shares i.e. 8.7M/ 100,000= $87. Rest of the investors will have $87 as the per share price and receive proportionate number of shares as- $$ ownership/ per share price

Case 2
Bonus factor- 25% instead of 20%

value of debt in beginning	250,000
bonus multiple	1.3
value of debt in conversion	312,500	=250,000*1.25

The post money valuation will remain the same. However, the ownership structure will change as below-

Group	$ value of ownership	% ownership	no of shares	per share price
1st round funding investor	1,000,000	10.0%	11,511	86.88
Convertible debt holder	312,500	3.1%	3,597	86.88
Promoter / founder	8,687,500	86.9%	100,000	86.88
Total	10,000,000	100.0%	115,108	86.88

As we can see here, the % ownership of convertible debt holders and 1st round capital providers has increased by that of promoters/ founders has gone down. The number of shares allocated to the founders is constant at 100,000. Hence, the per share price for all the investors has gone down.

Case 3
The convertible debt holders will get an equivalent ownership in the company post-valuation as if the company valuation was $5Mn in this case. The easiest and most common way to achieve this is to fix the % ownership of the convertible debt holders after valuation for $5Mn valuation and carry this % ownership to the fill valuation of the company.

value of debt in beginning	250,000
bonus multiple	1.2
value of debt in conversion	300,000	=250,000*1.2

Group	$ value of ownership	% ownership	no of shares	per share price
Convertible debt holder	300,000	6.0%	6,383	47.00
Promoter / founder	4,700,000	94.0%	100,000	47.00
Total	5,000,000	100.0%	106,383	47.00

As we can see here, the convertible debt holders will receive 6% ownership in the company after valuation, irrespective of the actual valuation of the company due to the $5Mn cap. The % ownership of the original founders will be adjusted to accommodate the changes. the new ownership structure will be as follows-

Group	$ value of ownership	% ownership	no of shares	per share price
1st round funding investor	1,000,000	10.0%	11,905	84.00
Convertible debt holder	600,000	6.0%	7,143	84.00
Promoter / founder	8,400,000	84.0%	100,000	84.00
Total	10,000,000	100.0%	119,048	84.00

As we can see here, the ownership of the founders has decreased from 87% in original arrangement to 84% in the case with valuation cap. The convertible debt holders has gained 3% additional stake in the company for the same investment. The 1st round investors have remained unchanged. This clearly stated the winners (convertible debt holder) and losers (founders) in the case valuation cap.