Convertible Debt Cap: Everything You Need to Know
A convertible debt cap, also known as a valuation cap, is the maximum amount at which an investor will change his or her investment into equity.3 min read
A convertible debt cap, also known as a valuation cap, is the maximum amount at which an investor will change his or her investment into equity.
Basics of Convertible Debt
Convertible notes are a type of short-term debt that can be converted, upon later financing, into equity shares of the company that issued them. This later financing is typically called qualified financing. For example, the note might specify that qualified financing is reached when the company raises more than $2 million in capital.
If a cap or discount is not issued, then a convertible note typically converts into equity at a price equal to the equity issued during that financing round. If a valuation cap is established, then it enables the investors to convert the note into equity at the lower of the current price of equity or the valuation cap listed.
A round of convertible debt gives investors the opportunity to invest in a debt vehicle knowing that it will eventually convert into equity. Early investors typically invest in convertible notes with the goal of converting to equity after some time.
A convertible debt round can have any of the following additions:
- A valuation cap.
- A conversion discount.
- Both a valuation cap and a conversion discount.
A valuation cap is defined as the greatest value investors will exchange their investment for equity shares.
A conversion discount is the rate at which the valuation in the financial round is converted from an investment to equity.
Calculating Convertible Debt
The following details must be known in order to calculate the conversion of a convertible note:
- Investment amount.
- Total shares outstanding.
The investment amount is the total amount invested in the current round. This total could be either the initial investment or the initial investment with interest.
A valuation is the listed value of the round before any money is involved. This is usually included in a Series A round or something like it.
The total shares outstanding are the shares outstanding prior to the conversion round.
The valuation that should be used is the lower of the following items:
- Valuation cap.
- Pre-money valuation.
- Discounted valuation.
A discounted valuation is the pre-money valuation of the round minus the conversion discount.
The next item determined is the number of shares that need to be issued to the convertible debt holders. This is calculated by dividing the valuation by the investment amount and then multiplying it by the number of shares outstanding.
This convertible debt round allows a business or an individual to receive financing without having to determine a specific valuation. Upon establishing a convertible debt round, the two parties come to an agreement concerning a valuation cap, a conversion discount, or both. Furthermore, this debt does not have to apply a specific closing time so investors can finance over an extended period.
Suppose an investor finances $100,000 into a convertible debt with a valuation cap of $2 million and a conversion discount of 10 percent. Assume that there are 50,000 shares outstanding.
For the first example, a venture capitalist contributes $2 million to a pre-money valuation of $4 million. Use the following steps to calculate the conversion:
- The lower of the pre-money valuation, the valuation cap, and the discounted valuation is the valuation cap of $2 million.
- Divide the investment of $100,000 by the valuation of $2 million and then multiply the total by 50,000. This totals a conversion of 2,500 shares.
For the second example, a venture capitalist invests $1 million to a pre-money valuation of $2 million. The following steps demonstrate the calculations needed to determine the conversion amount:
- The lower of the pre-money valuation, the valuation cap, and the discounted valuation is the conversion discount at $1.8 million.
- Divide the investment of $100,000 by the valuation of $1.8 million and then multiply the total by the 50,000 shares outstanding. This equals a conversion of roughly 2,778 shares.
Using Debt and Equity to Earn Capital
There are two ways in which businesses can earn capital:
Each option comes with different advantages and disadvantages. For example, debt is the less expensive form, but upon maturity, it must be completely paid back with interest.
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