The Pre-money vs. Post-money Confusion With Convertible Notes

The other day, Mark Suster wrote a critically important post titled One Simple Paragraph Every Entrepreneur Should Add to Their Convertible NotesGo read it – I’ll wait. Or, if you just want the paragraph, it’s:

“If this note converts at a price higher than the cap that you have been given you agree that in the conversion of the note into equity you agree to allow your stock to be converted such that you will receive no more than a 1x non-participating liquidation preference plus any agreed interest.”

I also have seen the problem Mark is describing. As an angel investor, I have never asked for a liquidation preference on conversion that is greater than the dollars I’ve invested. But, I’ve seen some angels ask for it (or even demand it), especially when there is ambiguity around this and the round happens much higher than the cap. The entity getting screwed on this term are the founders, who now have a greater liquidation preference hanging over their heads than the dollars invested by the angels. Mark has a superb example of how this works on his blog.

We’ve been regularly running into another problem with doing a financing after companies have raised convertible notes. Most notes are ambiguous as to whether they convert on a pre-money or a post-money basis. This can be especially confusing, and ambiguous, when there are multiple price caps. There are also some law firms whose standard documents are purposefully ambiguous to give the entrepreneur theoretical negotiating flexibility in the first priced round.

If the entrepreneur knows this and is using it proactively so they get a higher post-money valuation, that’s fair game. But if they don’t know this, and they are negotiating terms with a VC who is expecting the notes to convert in the pre-money, it can create a mess after the terms are agreed to somewhere between the term sheet stage and the final definitives. This mess is especially yucky if the lawyers don’t focus on the final cap table and the capitalization opinion until the last few days of the process. And, it gets even messier when some of the angels start suggesting that the ambiguity should work a certain way and the entrepreneur feels boxed in by the demands of his convertible note angels on one side and priced round VC on the other.

The simple solution is to define this clearly up front. For example, in the Mattermark investment from last year, I said “We are game to do $5m of $6.5m at $18.5m pre ($25m post).” When I made the offer, I did not know how the notes worked, what the cap was, or what the expectation of the angels were. But when Danielle Morrill and I agree on the terms, it was unambiguous that I expected the notes to convert in the pre-money.

In contrast, in the Glowforge deal, which Dan Shapiro talks about in his fun post Glowforge Completed its Series A with an Investor we Never Met, I was less crisp. I knew that Dan’s notes were uncapped with a discount and I knew his lawyer well, so I didn’t define the post-money in this case. Since the notes were uncapped, I expected them to convert into the pre-money. But I didn’t specify it. The notes were ambiguous and we focused on this at the end of the process after docs had gone out to the angel investors. Rather than fight about this, I accepted this as a miss on my part and let the post-money float up a little as a result. The total amount of the notes was relatively small so it didn’t have a huge impact on the economics of the investment but we could have avoided the ambiguity by dealing it with more clearly up front.

Recognize that this is simply a negotiation. In Mattermark’s case where there were a lot of notes stacked up, I cared a lot about the post-money. In Glowforge’s case where the note amount was modest, I didn’t care very much. And, while I care a lot about my entry point as an early stage investor, I’ve learned not to optimize for a small amount in the context of a pricing negotiation.

I think we are just starting to see the complexity, side effects, and unintended consequences created by the massive proliferation of convertible notes over the past few years. I’m pretty mellow about them as I’ve accepted that they are part of the funding landscape, in contrast to a number of angels and VCs who feel strongly one way or the other. As derivative note vehicles have appeared, such as SAFE, that try to create synthetic equity out of a note structure, we’ll see another wave of unintended consequences in the next few years. As someone who failed fast at creating a standardized set of seed documents in 2010, I’ve accepted that dealing with the complexity and side affects of all of the different documents is just part of the process.

Fundamentally, it’s up to the entrepreneur to be informed about what is going on. I hope Mark’s blog post, and this one, are additive to the overall base of entrepreneurial knowledge. And, if Jason and I ever write a third edition of Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist our chapter on convertible notes might now be two chapters.

  • Peter Werner

    Thanks Brad. This is great. If an investor doesn’t have full information about the company’s cap table and note terms, I like to suggest that they cover their bases by expressing their investment as a % of the post (i.e. “investing $3 million of a $5 million total round at a $30 million post, for post-money ownership of 10% assuming the full $5 million is invested.”).

  • When an angel converts at a post-money valuation when the convertible note is turned into equity then essentially the angel is screwed. You might as well have invested in a note with zero cap. I am so over the note.
    I get a side letter so I don’t get hosed after a lesson learned. One lesson is all I needed.

    • Joanne – this is very different than what I’m talking about. I’m not sure what your specific example is – I’d love to hear more.

      In the case where there’s a cap, your valuation is the cap. If the note is included in the post-money, the angel actually gets MORE benefit because the pre-money is effectively higher (since the note doesn’t count against the pre-money of the priced round).

      In the case where there’s no cap, but a discount, the angel again gets benefit if the note is included in the post-money (vs. the pre-money).

      • You are right. My bad. It meant when the note converts at the pre-money.

      • Yep, that’s right… hope my math is right, Brad!

        Convertible (cap is at post-money valuation)
        Cap (post-money cap): $3.5M
        Raise: $0.5M
        Discount: 20%
        Interest: 0% (for simplicity)

        Series A:
        Pre-Money Valuation: $6M
        Raise: $2M
        Post-Money Valuation: $8M
        Cap or discount applies?: The Cap of $3.5M applies
        Post-money Valuation for the seed-stage investors: $3.5M
        Assuming no further investment, seed-investor equity stake is now: 14% ($0.5M / $3.5M)

        Convertible (cap is at pre-money valuation)
        Cap (pre-money cap): $3.5M
        Raise: $0.5M
        Discount: 20%
        Interest: 0% (for simplicity)

        Series A:
        Pre-Money Valuation: $6M
        Raise: $2M
        Post-Money Valuation: $8M
        Cap or discount applies?: The Cap of $3.5M pre-money applies
        Post-money Valuation for seed stage investors: $5.5M ($3.5M cap + $2M raise)
        Assuming no further investment, seed-investor equity stake is now: 9% ($0.5M / $5.5M)

  • I’ve been running scenarios especially where angels want to run pro-rata and its wierd when awesome investors want to follow on at the new cap but are surprised by the pro-rata they need to maintain ownership.
    Esp when the note converts at pre-money – But I’ve been super diligent to explain the potential share issuances / allocations to everyone – Its a bit more work but I’m happy to do that math to keep my investors’ trust.

    I do prefer the convertible note because it helps with speed, flexibility and opens up a lot more investors who would otherwise get uncomfortable and using standard documentation is helpful.

    There are caveats and If a new standard comes along – the SAFE, KISS or whatever else – I’d be happy if its better.


  • I used to be mellow about notes, but I am not anymore. I would rather not do a note, and prefer equity for lots and lots of reasons. You give a great example why in your post. What I am seeing is notes get help open almost indefinitely, they fill up with lots of disparate investors with different goals and wants. If they ever get to a priced round, it potentially be incredibly difficult to close with all the cats to herd. I recently went through a note conversion, and was very active in cleaning up the cap table before we went out to raise more financing.

    As the caps on notes creep up, I’d rather just have the equity discussion. I think I saw Dave McClure tweet, “why don’t you give me a 2x liquidation pref on your 6M cap?”

    More founders ought to explore using warrants or options instead of notes with a discount.

  • stevewfindlay

    We covered a very similar issue in our post on “Convertible Debt Shuffle”

    This is part of a free Cap Table University series we’ve created covering many of these issues – enjoy, and please feel free to request a topic if we are missing anything. #PayingItForward

  • Super interesting

  • When I learned you were leading the Mattermark deal, I stopped worrying about getting screwed, as you were fair to previous investors while closing this deal.

    • Were you an angel in Mattermark or before the re-launch?(Danielle doesn’t like to call it a pivot, I think.)

  • Call me old-fashioned, but if I were raising money I’d do my best to seek an equity deal, even in the early rounds, as opposed to postpone the pricing question and be stacking notes. But what do I know?

  • Katherine Chambers

    So grateful for awesome, relevant and experienced advice. Thanks for the transparency in educating us all.

  • ZekeV

    This makes me wonder about some of my own note docs. I have often expressed the discount vs. price per share paid by the series investor, which would seem to be a post-money measure. This is easy to draft, but does it create a problem?

    The cap is more easily expressed in terms of implied valuation rather than price-per-share. But if you don’t hit the cap, then the post-money valuation will be a function of both the conversion of notes and the series investment terms. If the series investor simultaneously says “I will do $5mm of 20 pre / 25 post” this is equivalent to paying $5mm for exactly 20% of fully diluted cap, all else held equal. If a $1mm seed note converts at a 1/5 discount to that price, the seed investor should get 4% right? But where does that extra 4% come from? It’s impossible. The lawyers would have to say, hey, this valuation doesn’t work with the note’s conversion feature — we can still get the series investor 20% of the company, but the effective post-money and price-per-share would adjust. That is, the extra 4% would come from the founders.

    So if you have leverage, you could always get what you need as a series investor. But the founders would have to take the hit, I suppose.

    • In the hypo you describe, the notes convert as part of the pre-money capitalization, which means that I (as startup lawyer with Excel skills) calculate what the de facto original issue price for those discount convertible note shares will be and treat them as issued for the purpose of calculating the fully diluted capitalization of the company for the purpose of calculating the original issue price for the new round of preferred. Then it all goes on to the cap table post-deal.

      To me, convertible notes should generally be part of the deal and not part of the pre-money, as with their forgotten precursor, the bridge note. A good way of doing that is ensuring that you’ve built that disclosure and structure into a term sheet from the beginning, just as you would with an early investor who threw in some bridge financing.

  • In hindsight, I’d do my seed raise differently the next time. Too much money was left on the table explaining what a convertible note is, does, is worth, converts at….etc. I’d rather have spent my time selling my vision, building and shipping good product and focusing on customers / users.

  • I just re-read Venture Deals last week — a 3rd edition someday would be awesome. I’d be up for collaborating/helping on the development front if you’re ever interested in creating a living breathing eBook/app version.

  • You know what I think of convertible notes. You even elude to it a couple times in your post. ENTREPRENEURS: Don’t take convertible notes at any point in your financing. There’s no upside for you. They’re designed to increase the reuturn for the VCs and as is evidenced here, make things more complicated, which is to the benefits of the VC. Do simple debt or equity financing only!

  • Samaira Khan
  • Robert Ausposito

    Another reason to eschew convertible notes…which are bad for investors and companies alike since they don’t provide total alignment. SAFE is equally bad. The only thing that makes sense is equity (series seed is the easiest and great option) since it aligns all perfectly from the get go and all issues like the ones Brad describes are gone. It also allows for everyone to agree on a valuation based on all the information available at the time of investment — and then move on to succeeding or failing together. There is no better way.

  • I put a couple examples of pre and post-money Caps in the following post:

    Still reference it myself as it’s easy to get tripped-up! = ]

  • teddybeingteddy

    Brad please help – I’m an idiot and have always had a mental block on post $ valuation. If a company was worth $10MM yesterday, and you invest $2MM today, why would anyone agree the company is suddenly worth $12MM and thus the basis for your [17% not 20%] equity ownership? Should a change in cap structure (not cash flow, margins, contracts, or revenue) really change the underlying value of a company? Are you basing ownership allocation on liquidation value or enterprise value? (I realize this is a dumb VC 101 question, but I just don’t get it)

    • teddybeingteddy

      Further, if the company is worth $12MM today after your $2MM investment – didn’t you create 100% of that value? If so, why should you be punished for it?

    • Just think about it in really simple terms. Suppose you founded a company and invested $2 for 2 shares. Then I come along and want to invest at the same price per share of $1, which implies a pre-money of $2. After the investment, you own 2 shares and I own 1 share – 66.6% and 33.3%, respectively.

      My 33.3% can be calculated as ($1 investment / the $3 post-money) or (1 share / 3 shares outstanding). To calculate my ownership using ($1 investment / $2 pre-money) does not correctly reflect what actually happens in terms of ownership.

      • TeddyBeingTeddy

        Thanks for the response Todd, sincerely. I get your math, but it seems like your valuation is solely based on the $ of cash equity put into it…not the amount of cash flow that might be coming out. If everything is based on post money valuation, what’s the difference between a startup and Ponzi scheme (the only real value is cash people are tricked into investing, the rest is smoke and mirrors)?
        Again, I know I’m in the wrong here as it’s just how VC is done…but it doesn’t make sense if you’re truly investing in a viable business, and not a bank account?
        E.g. if I bought $1MM shares of Apple today, Apple isn’t suddenly $1MM more valuable…correct? Because [Apple] creates value by generating products and revenue streams (versus creating value by finding more investors to park their cash). No?

        • When you buy existing Apple stock, nothing changes. If Apple issues more stock and you buy it, then the valuation changes because “The New Apple” consists of the original Apple business + the money you paid for those new shares.

        • If you went and bought $1M worth of existing Apple shares on the stock exchange, you’re correct, Apple would not suddenly be worth another $1M, because your $1M goes to whoever owned those shares previously.

          But, if Apple issued you NEW shares for $1M, then the cash you pay for those shares goes straight onto Apple’s balance sheet, so Apple’s market value would increase by $1M.

          Try thinking about it this way: if your company has $1M cash on the balance sheet, and you have no prospects of generating future cash, then your company is worth $1M.

          On the other hand, suppose you have no cash on the balance sheet, but the market thinks your company has the ability to generate cash in the future, and they decide that the present value of that future cash is $5M. If they invest $1M cash, your company is now worth $6M ($5M present value of future cash + $1M of current cash).

          This is really all that’s behind the pre- and post-money valuations. In my simplistic example, the pre-money valuation was nonsensical; it merely helped explain the math. In reality, the pre-money is not based on money that has already been invested, but rather investors’ estimation of value based on future cash flow prospects.

          • TeddyBeingTeddy

            Yup – you are obviously correct. I didn’t realize it was implied new shares were being issued. I thought existing s/h were selling to new investors. #doh! #aha!

    • Think of it as two companies merging. The one company is the one worth 10 million dollars, the other ‘company’ is 2 million in cash valued at, well, its cash value.

      If you merged your 2 million cash with another company worth 10 million, how much would you get in the combined company? 2 / (10+2), so 16.66…%

      • TeddyBeingTeddy

        Thanks Peter – I guess my same reply to Todd’s below comment would also apply to yours. Again, knowing my logic is flawed…but I still don’t quite get it. If we were talking about the value of a savings account…I agree. You put in 10, then I put in 2, then the account is worth $12. 2/12 = my ownership. But that’s a bank account. Not a business. Ultimately I guess my question is…should the cap structure determine the value of the business, or should the revenue and/or EBITDA determine the value of the business? (“both” and “it depends” aren’t options!)

        • You are confusing buying existing stock and new stock.

          1) You buy 2 million USD of Apple Stock. Apple’s valuation does not change, because you buy the existing stock from an existing shareholder. The business does not change.

          2) You buy 2 million USD of NEWLY ISSUED (preferred) stock from my startup. The cash does not go to me (the original investor), but to the company. So the business does change, it now has 2 million more than before (i.e. cap structure changes). So the new value is $whatever_we_agreed_was_the_pre_money_valuation + $amount_of_cash_invested_INTO_business. So in our example, 10+2 = 12 million.

          By the way, I will have to say “both” on whether cap structure or EBITDA determines business valuation. The $amount_of_cash_invested_INTO_business is a cap structure change driven change in valuation, the $whatever_we_agreed_was_the_pre_money_valuation is determined by the expected EBITDA taking into account the extra money from $amount_of_cash_invested_INTO_business.

          I have exhausted the different ways in which I can explain this now.

          • TeddyBeingTeddy

            that is very helpful actually. I didn’t realize new stock was being issued, I thought existing s/h were selling…not issuing new. All makes sense now (the AHA! moment!). I personally think the only way a cap structure should change valuation is tax impact (338H10s, NOLs, etc.) but I’ll spare that discussion for another day. In any case, thanks for taking the time on a thoughtful response! I learned something today!

          • It’s not cap “structure” changing valuation but actual new capital. After the closing, the business consists of everything it did the day before plus $2m cash in the checking account. The company’s valuation is the valuation of the whole; the equity cap structure is the dividing of that whole into parts, which is, as you note, generally irrelevant (nothing changes if you do a 3:1 split or half your shares go to a divorcing spouse).

  • Dan Pengue

    If my capital structure includes Convertible Notes with a valuation cap, do VCs really care if they convert at a pre or post money valuation given that their conversion price (assuming the valuation is > than the cap) is already fixed?

    • They care a lot about where the folks in the note convert. I tried to explain it in the post.

  • James Billmaier

    Is it more common practice to convert a capped note prior to the new priced investment dollars (advantage new investor assuming valuation is fixed) OR is it more common practice to convert the capped note simultaneous with the new priced investment (which effectively increases the pre-money valuation)?

    • There isn’t a common practice – it varies widely by deal.