Pre or Post?

We had a conversation with a company this week around a convertible note and it led to an unexpected question in my mind.

This company is raising a priced round and has quite a few convertible notes that will convert into this new round. The dollar amount is significant in relation to size of the round. However, the note terms did not specify if it converts pre or post money as most notes do. Since we normally convert pre money in these situations, the conversation went something along the line as follows (note: I am changing the actual numbers to protect the privacy of the conversation but the jist is the same):

Me: “So your raising $2m on a $6m pre, thus an $8m post”

Entrepreneur: “No, we have $2m in notes so it’s a $6 pre and $10m post”

Me: “But the note terms don’t specify if they convert pre or post, we typically see it convert pre.”

Entrepreneur: “Our lawyers advised us that converting post money is market”

Two things. One, I always define both pre and post for this very reason. Learned this lesson from Brad Feld in his post on notes. This is exactly why I do this and it’s a great habit to get into as an investor.

Second, this was a very savvy response by the entrepreneur and despite any hesitancy to convert post money (for reasons explained below), it showed a level of sophistication on their part that most entrepreneurs wouldn’t have.

The reason investors always want to convert pre money is that converting post money immediately dilutes the new investors. Reason is that the notes have a discount or valuation cap, which means more shares are created than would have been if they had the same price as the new investors. Thus new investors get diluted down immediately upon financing.

Btw, I’m not against the discount. Note investors invested earlier, thus it was more risky and they should be compensated for that risk. I’m not arguing one is right or wrong, just what is.

If its small amount, no big deal but in this case it made a significant impact.

But here was the most surprising aspect of the whole thing. In every deal but one, we have always converted pre money. That one time it was specified in the note terms. Afterwards we contacted two different lawyers and both said they typically see it convert post money.

I was a little shocked. I was under the impression converting pre-money was far more common.

So my question is this, which is more common, converting pre or post?