I have been recently asked by several clients how will a convertible debt investment with an agreed valuation cap affect the ownership structure of a company. Therefore, I decided to share with you a brief example that might help you understand the impact.
Company XYZ with two founders gets a convertible debt of EUR 50k with an interest rate of 5% p.a. and a valuation cap of EUR 400k. Each of the founders has a 50% share of the registered capital in the company. After one year, the company raises a qualified investment of EUR 100k with pre-money valuation of EUR 500k. How does this investment affect the ownership structure?
The new investor gets a company share of 16,7% from his EUR 100k investment. Why? Because the value of his investment is EUR 100k and the “value” of the company after his investment (note: post-money valuation) has reached EUR 600k.
What share would the new investor have if he invested via convertible debt? If we took into consideration 5% p.a. interest rate, then the value of his claim would be EUR 52,5k in one year. That’s because he has agreed on a valuation cap of EUR 400k, therefore, his share in the company XYZ before arrival of the new investor reaches around 11,6%. However, due to the investment, there is standardly (note: depending on the signed term sheet and type of valuation) a decrease of his share too. In this case, his company’s share will be around 9,7%.
The share of the company of the two initial founders will decrease from 50% to 36,8% each. However, in practice, various situations might occur, e.g. the down round, which has several possible solutions, which depend on the negotiation between founders and investor.