Financing Fundamentals: Equity Funding, Convertible Debt & Dilution

Convertible Debt Financing: A Popular Way for Startup Companies to Raise Their Initial Round of Seed Funding

Imagine that you’re cruising along coast highway in your convertible and you realize that you soon are going to run out of gas.  You need to fuel up so that you arrive on time to your next destination. Translation in startup speak: You raised the seed round for your company with convertible debt.  And, given your company’s current Burn Rate, you now need to raise your Series A Preferred Stock financing round, so that your company can reach its next milestone or cash flow breakeven.

In too many cases, the Founders and company executives are happy to take in the money without knowing the future equity ownership consequences that will result from the terms of the convertible debt financing.

• How much equity (or stock ownership) Dilution will result from the conversion of the Convertible Debt into shares of the next equity financing?
• How do you model the conversion discount to the price per share in the next equity financing?
• What if the Convertible Debt investors have required a conversion valuation cap?  How is this modeled in the next equity financing round?
• How do you set the terms of the next equity financing round to lower the equity dilution resulting from the prior Convertible Debt financing?

As you can tell, the prior convertible debt financing adds a lot of complexity to the next equity financing round and raises a number of questions and issues.

If you first raised a Seed Round with Convertible Debt and now are raising capital through an equity financing round (e.g., sales of shares of Common Stock or Series A Preferred Stock), then you need to model the financing and understand how the terms of the prior Convertible Debt financing, together with the proposed terms of the new equity financing, will affect your company’s equity capitalization table and resulting stock ownership after the new equity financing is completed.

But don’t worry – we’re here to help.

We have created an equity financing model for you to download below and use to plan your company’s next equity financing round.  And it covers the prior Convertible Debt financing and related conversion mechanics.

Key concepts covered in the equity financing model include:

1.  The existing fully-diluted capitalization of your company, plus the related fully-diluted ownership percentages for the various items of the current equity capitalization;

2.  Various calculations relating to the prior convertible debt financing, including:

• the calculation of interest through the closing date of the new equity financing round, so that the full conversion amount is calculated;
• the conversion price per share of the new equity security after taking into account the convertible debt discount and, as applicable, the conversion valuation cap; and
• the resulting number of shares of the new equity security to be issued to the holders of convertible debt;

3.  The estimated “pre-money” valuation of your company, the estimated total investment and the resulting “post-money” valuation of your company;

4.  Calculation of the number of shares of the new equity security to be sold, and the related price per share, in the financing, after taking into account the effects of the conversion of the Convertible Debt;

5.  The fully-diluted capitalization of your company after the new equity financing, plus related fully-diluted ownership percentages for the various items of the “post-money” equity capitalization; and

6.  Resulting equity dilution resulting from the new equity financing and the conversion of the Convertible Debt.

This equity financing model will allow you to test drive various financing scenarios that take into account the terms of the Convertible Debt financing.  You can use this model either (i) before the Convertible Debt financing in order to understand how its conversion will affect the next equity financing, or (ii) after the Convertible Debt financing but before the next equity financing round, so that you properly model the debt conversion and the various terms of the next equity financing.

Know where your financings are taking your company by entering your name and email address below, and we will send the equity financing model to you.

Let us show you how to use the model:

We also have created two explanatory videos below (one short and the other with more guidance) to help you use the spreadsheet more effectively.

Your Turn:

Please let me know if you have any questions or comments about the equity financing model.  Your input will help other entrepreneurs who may have similar questions.