Dilution: Priced Rounds vs Convertible Notes

There have been many posts by investors articulating the issues with convertible notes. Most recently, Fred Wilson wrote that one of his main issues with notes is that they “obfuscate the amount of dilution the founder(s) is taking.”

While there are more aspects of notes that entrepreneurs may not think about (see Fred’s post) I will solely focus on dilution for this post. I build out 2 examples (equity vs. notes) and 2 rounds within those examples (“pre-seed” and “institutional seed” rounds).

Example 1: Equity

Terms: $1M at $3M pre-money valuation, 20% employee option pool.

As you can see, the Founding Team owns 55% of the Company after the round. The rest of the cap table is clean and everyone knows exactly what they own.

Now, let’s assume that, about 18 months from Round 1, the Company demonstrates enough traction to raise a $2M round at a $6M pre-money valuation. The investors set the option pool to 18%, to be reflected in the pre-money share count (ensures new money in doesn’t get diluted by increase in option pool). Round 1 investors also take their pro-rata.

At the end of the 2nd round, the Founding Team owns 39.19% of the Company.

Example 2: Convertible Note

Round 1 Terms: $1M at a $4M valuation cap; 20% discount on the next round; 7% interest; 20% employee option pool at Company formation.

Here, the cap table reflects the investment (as debt), but does not effect ownership of in the Company. The Founding Team owns 80% on the cap table, but in reality it is somewhere much less than that (most likely around 55%). Depending on a variety of factors, though, the Founders really do not have a clear idea of how much of the Company they own. And as many have noted, this puts the Company in a slightly precarious situation.

Now, about 18 months later, the Company raises an equity round with the same terms as Example 1: $2M at a $6M pre-money valuation. In this case I simply doubled the employee option pool (which results in the same 18% ownership in this specific example).

Round 1 Investors converted at the $4M cap as opposed to the 20% discount. The Founding Team, though, end up with 36% of the Company, whereas in Example 1, they ended up with 39%.

The difference then, at the same terms, was ~3% extra dilution by taking a convertible note instead of equity.

This 3% can be substantially increased if founders take on more capital on the notes, offer a lower cap, or a larger discount. In a few different permutations of this model, the delta ended up being 6%-8%.

At the end of the day, the fact that founders are taking “extra dilution” is not the problem. It’s the fact that many aren’t realizing it. And when it comes to the date when this is realized, it can understandably be extremely unsettling.

So, if you’re a founder and want to play with the different scenarios, feel free to reach out to me and I can share this model with you.