Posted By
Derek Colla

Now that you have agreed on a company valuation with your investors, how do you calculate the price per share for your Series A financing?  This can be especially tricky when the company has outstanding convertible notes that are converting into shares of preferred stock in connection with the Series A financing.

Price per share without convertible notes

Often the situations plays out as follows: you receive a term sheet from an investor offering to purchase $2 million of preferred stock with a purchase price based upon a pre-money valuation of $8 million and a post-money valuation of $10 million, implying a 20% ownership position for the investor following the financing. If you do not have any convertible notes outstanding, then calculating the price per share for the new investor is straightforward – it is the pre-money valuation divided by the shares outstanding on a fully-diluted basis. Post-financing, the new investor would own 20% of the company, and the existing stockholders would continue to own 80%.

Price per share with convertible notes

The situation becomes more complex when you have convertible notes converting into equity. Since shares are issued upon conversion of the notes and the note holders will thus own some percentage of the company, once the transaction is complete either the existing stockholders will own less than 80% of the company or the investors will own less than 20%. Another way of saying this is that either the true pre-money valuation will be less than $8 million or the new investor will own less than 20% of the company after the transaction is completed. The key questions are (1) whose ownership percentage is diluted by the issuance of the shares on conversion of the notes; and (2) by how much is each party diluted.

As you can imagine, entrepreneurs and investors often have different views on how to resolve this question and a few different methods have become commonplace resolutions. Here are the three most common methods, including some examples to provide you with an understanding of the practical impact.

Assumptions

  • Agreed Upon Pre-Money Valuation: $8 million
  • Agreed Upon Post-Money Valuation: $10 million
  • Amount Being Invested by New Series A Investors: $2 million
  • Principal Plus Accrued Interest on Outstanding Promissory Notes: $1 million
  • Discount Rate for Conversion of Notes: 30%
  • Shares Outstanding on a Fully-Diluted Basis, Pre-Investment: 1 million

Pre-Money Method

In the pre-money method, the pre-money valuation of the company is fixed and the conversion price for the notes is determined based on that. Using the assumptions above, the price per share for the new investors would be $8.00 per share ($8 million divided by 1 million shares) and the conversion price for the notes would be $5.60 per share ($8.00 minus the 30% discount). The equity ownership of the company pre- and post-investment would be as follows:

Stockholder Group Pre-Investment Post-Investment
Shares % Ownership Shares % Ownership
Founders 1,000,000 100% 1,000,000 70%
Noteholders 0 0.00% 178,571 12.50%
Series A Investors 0 0.00% 250,000 17.50%
Total: 1,000,000 100% 1,428,571 100%

The pre-money method causes both the Founders and the Series A Investors to be diluted by the shares issued upon conversion of the notes in proportion to their ownership percentage. While the pre-money valuation stays fixed at $8 million, the post-investment percentage ownership of the Series A Investors is 17.5% and the post-money valuation implied by this method is $11.43 million. While this is probably the most common method, many investors dispute its use since it results in them having less ownership of the company than that for which they believe they bargained.

Percentage-Ownership Method

In the percentage-ownership method, the percentage ownership of the company that the investor is purchasing is fixed and the other variables are computed based on that. You would come to the same result if you fixed the post-money valuation. Using the assumptions above, the price per share for the new investors would be $6.57 per share (mathematical result to arrive at 20% ownership) and the conversion price for the notes would be $4.60 per share ($6.57 minus the 30% discount). The equity ownership of the company pre- and post-investment would be as follows:

Stockholder Group Pre-Investment Post-Investment
Shares % Ownership Shares % Ownership
Founders 1,000,000 100% 1,000,000 65.71%
Noteholders 0 0.00% 217,391 14.29%
Series A Investors 0 0.00% 304,348 20%
Total: 1,000,000 100% 1,521,739 100%

Dollars-Invested Method

The percentage-ownership method causes all of the dilution that results from the shares issued upon conversion of the notes to be borne by the Founders. While the Series A Investors’percentage ownership remains fixed at 20% and the post-money valuation remains fixed at $10 million, the pre-money valuation implied by this method is $6.57 million and the Founders’ ownership percentage is less than it is using the pre-money method. Unless it is expressly indicated in the term sheet, many entrepreneurs consider using this method to be a material deviation from the agreed upon term sheet and object to its use.

The dollars-invested method is often utilized as a compromise between the pre-money method and the percentage-ownership method. In the dollars-invested method, the post-money valuation of the company is fixed to equal the agreed upon pre-money valuation plus the dollars invested by the new investors plus the principal and accrued interest on the notes that are converting. Using the assumptions above, the post-money valuation would be fixed at $11 million and each of the other variables would be calculated from that. In this example, the price per share for the Series A Investors would be $7.57 per share and the conversion price for the notes would be $5.30 per share ($7.57 minus the 30% discount). The equity ownership of the company pre- and post-investment would be as follows:

Stockholder Group Pre-Investment Post-Investment
  Shares % Ownership Shares % Ownership
Founders 1,000,000 100.00% 1,000,000 68.83%
Noteholders 0 0.00% 188,679 12.99%
Series A Investors 0 0.00% 264,151 18.18%
Total: 1,000,000 100.00% 1,452,830 100.00%

Conclusion

The dollars-invested method gives the Founders credit for principal and accrued interest on the notes that are being converted into equity as if these were funds being newly invested into the company, but only the Founders are diluted by the “extra” shares that the noteholders are receiving due to the conversion discount. The rationale is that converting debt into equity without a discount does not change the Series A Investors’ percentage ownership of the enterprise value of the company, so they are still getting the deal for which they bargained. The Founders have to compromise and accept some additional dilution, but it is significantly less than what they would suffer under the percentage-ownership method.

The hardest part about calculating the price per share in a Series A financing of a company that has convertible notes converting at a discount is that it effectively re-opens the discussion about the valuation of the company. Each party may have thought they had an agreement and now one (or both) needs to compromise to get the deal done. Hopefully, this article has helped you  understand some of the different options for solving the problem so you can tailor your approach accordingly.