Why convertibles make more sense by setting a post-money cap
A simple change that can reduce complexity for early-stage financings
A challenge that I see founders struggle with when raising money using a convertible (note: I’ll use convertible as a term to capture advanced subscription agreements (ASAs) and/or simple agreements for future equity (SAFEs) throughout this post) is correctly understanding the dilution they are taking. This has traditionally been one of the advantages of doing an equity round (where shares are issued at the time of investment) because it allows everyone to have a clear picture when the round closes of where they stand from an ownership perspective. However, for multiple reasons (time, cost etc.) often an equity round isn’t a founder or investors preference at the earliest stage.
I think there is a simple fix to this problem, set the cap in the convertible as a post-money valuation. In this scenario, the post-money is in relation to any money raised under such convertibles (see below for an example) but, to flag, is not inclusive of the money raised at the converting round (i.e. Seed or Series A). This is something that we have incorporated in the standard advanced subscription agreement we’ve been using for our pre-seed investments at Seedcamp. It’s also something that YC have recently incorporated in their standard deal documents.
So, how does this work in practice?
Firstly, I’ve written previously about considerations to bear in mind when setting caps. If you haven’t checked that out, I’d recommend starting here.
The difference between using a post-money and a pre-money cap is best illustrated using numbers:
Post-money
If you were to raise £100k and set a cap at £2m post money then on conversion at the cap the investor would own:
- £100k / £2m * 100 = 5%
If you raised an additional £150k on the same cap that would add an additional:
- £150k / £2m *100 = 7.5%
- Total dilution => 5% +7.5% = 12.5%
Pre-money
Suppose you went out to raise £100k and agreed to give up 5% of your company for this. Using an ASA you, therefore, set a cap at £1.9m pre-money. On conversion at the cap the investor would own:
- £100k / (£1.9m +£100k)*100 =5%
So far the same as the post-money scenario. If you then went on to raise an additional £150k on the same cap that would add the following dilution:
- £150k / (£1.9m+£250k)*100= 6.97%.
This is lower than the post-money scenario because the additional amount raised has been added to the pre-money cap resulting in a new cap for the purposes of calculation.
Furthermore, as the cap has effectively increased by this additional £150k, the original £100k would now equate to the following dilution:
- £100k / (£1.9m + £250k ) * 100 = 4.65%
- Total dilution => 6.97% + 4.65% = 11.62%
The above is a very simplified example but you can imagine how complex this can get when using a pre-money cap to raise investment from multiple investors.
Why the concept of time is crucial
As the above illustrates, the pre-money example actually results in less founder dilution and therefore could be seen as founder favourable. This is because each incremental amount raised using a post-money cap just dilutes the current shareholders which at the pre-seed stage are usually the founders. However, I think the key concept to layer onto this analysis is time. A startup can be seen as having a value attributable to a certain period in time. The post-money method allows founders to clearly define what the valuation of their startup is for a period of time that they will raise convertibles for. Often this time period is pre a large institutional Seed or Series A. By clearly defining this time and setting the post-money cap for this period it allows founders to have a very clear picture of the dilution they are taking at each funding event documented using a convertible and therefore where they stand going into the Series A. Obviously if this time period is particularly long, a founder could determine that there are two or more distinct periods prior to the large institutional Seed or Series A and therefore there is a higher cap for the second or additional period. There are numerous ways that founders and investors can get creative to structure such financings but I think a key driver should be simplicity and speed and the post-money approach helps with this.
The exact timing of when the mechanic of conversion takes place is another area that can cause confusion. For example, often convertibles are drafted as being inclusive of an option pool that may be requested at the round in which it converts. This can add additional dilution for founders because it means that the dilution of the future option pool comes before the convertible is converted and is therefore borne by the founders and not the note holders. This is not a particularly unusual provision but it is something for founders to be aware of. For example, a pre-money cap that is inclusive of any option pool could end up resulting in a similar level of dilution as a post-money cap not inclusive of an option pool.
Overall, I think the focus should be on simplicity and speed. I do think navigating to a post-money world helps with this and provides a clearer basis for founders and investors alike.
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