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You may have heard of the "Option Pool Shuffle", but in our latest instalment of our Cap Table University Series, we introduce the "Convertible Debt Shuffle". Following on from our post on Convertible Debt Rounds

In short, the Convertible Debt Shuffle impacts the shares allocated to a VC, when a Convertible Debt Round has been triggered by a VC investment. There are two ways to determine the shares to allocate to the VC, and the price paid per share:

  • VC Friendly method:
  • Convert the Debt Round first, allocating their shares using the number of shares outstanding (see below, or our earlier post on convertible debt for this). Then, using the revised number of shares outstanding, allocate the VC their shares, based on the amount they've invested

  • Founder Friendly method:
  • Allocate both the Convertible Debt Round and the VC shares based on the same amount of shares outstanding

This seems a subtle difference...so what's the issue...
In the VC Friendly approach, the VC gets more shares, but the Converting Debt Round (and Founders) will pay more per share than their conversion discount implies.
In the Founder Friendly approach, the VC gets less shares, but the Converting Debt round will pay the correct price per share, in accordance with their conversion discount

Worked Example: 

Here's how it works in practice, let's say:

  • A seed investor invests $500k into a Convertible Debt round with a Conversion Cap of $4M and a Conversion Discount of 25%
  • The company has 100,000 shares outstanding (all owned by the Founders)
  • A VC invests $2.5M on a pre-money valuation of $5M
  • First, we work out which valuation to use to convert the debt. The lower of:
    1. the pre-money valuation: $5M
    2. the Conversion Cap: $4M
    3. the Conversion Discount applied to the Pre-Money Valuation: 25% off of $5M = $3.75M
  • So we use the Conversion Discount valuation of $3.75M to convert

But this is where things get interesting....

Example 1: VC Friendly

  • The Convertible Debt investor converts first: they get ($500k / $3.75M) * 100,000 = 13,333 shares. Effectively paying $37.50 per share
  • There are now 113,333 shares outstanding
  • The VC then converts their $2.5M investment at a valuation of $5M and gets ($2.5M / $5.0M) * 113,333 = 56,667 shares. Effectively paying $44.12 per share
    But, this means:
  • The Convertible Debt investors paid $37.50 a share, and the VC paid $44.12 a share: this is a 15% discount not a 25% discount!
  • The VC now owns 33.3%, the Founders 58.8% and the Convertible Debt investors 7.9%

Example 2: Founder Friendly

  • The Convertible Debt and VC investor convert at the same time:
    • the Convertible Debt investors get ($500k / $3.75M) * 100,000 = 13,333 shares. Effectively paying $37.50 per share (as before)
    • The VC converts on the same basis, their $2.5M investment at a valuation of $5M and gets ($2.5M / $5.0M) * 100,000 = 50,000 shares. Effectively paying $50.00 per share
    Spot the difference:
  • The Convertible Debt investors paid $37.50 a share, but this time the VC paid $50 a share: the 25% discount is valid
  • The Founders own 61.3% and the Convertible Debt investors 8.2%
  • the VC owns 30.5%, which they would be upset about, given that they thought they were investing $2.5M on $5.0M, and should get 33%...

What does that all look like...

The VC clearly pays more per shares under the Founder Friendly Approach, this gives the Convertible Debt holders the correct discount (25%):

Cap Table Debt Shuffle Price Paid Per Share

But, as a result, the VC gets a smaller shareholding in the Founder Friendly Approach - almost 10% less (30% vs. 33%):

Cap Table Debt Shuffle Ownership under VC Approach

Cap Table Debt Shuffle Ownership under Founder Approach

Ok, so which is correct...
Well the answer is never easy. Both approaches are valid. There are good arguments for and against both approaches. here's some examples from the market:

  • Brad Fled illustrates a point using the Founder friendly approach (note the share price paid by each investor - the conversion discount is consistent)*
  • Mark Suster also uses the Founder friendly approach (see the math in the red section)*
  • Fred Wilson also implies a Founder friendly approach (see the paragraph on discounts)*
  • The Founder Institute and The Funded convertible debt termsheet (as reported on Techcrunch) implies a Founder friendly approach (note the "price per share" definition)
  • However, experience has also shown us the VC friendly approach is widely adopted by many VCs

*Please note that each of these posts, had a primary purpose other than illustrating the Convertible Debt Shuffle, and in each case the math was much simpler using the Founder friendly approach. So it may not be appropriate to say that these reflect the preferred approach to the Convertible Debt Shuffle for each author

Inevitably it will depend upon your pre-existing legal documentation, and what the investors - existing and new - are prepared to accept.

You may also need to consider the impact of any new Shares Options that are made available as part of the new round (see our post on the Option Pool Shuffle), and whether the converting debt holders will benefit from any of the Series A terms, such as Liquidation Preferences. These can all be traded in the negotiations...along with the pre-money valuation

The best thing you can do, is give the VC a clear understanding of your cap table as early as possible in discussions. So they can be clear about the impact of convertible instruments, and how these are converted, before agreeing a pre-money valuation. That way, it is not left to the last minute to resolve conflicting interests between your existing investors and your new ones. This is easily done by creating and sharing your Reportally Cap Table

One technical thought: you can make the maths work, if the Convertible Debt Round conversion discount is applied to get the Convertible Debt Post Money Valuation, and then you adopt the VC Friendly approach. This ensures the Convertible Debt holders get the correct discount per share, and the VC gets the right ownership.
But we've never seen a Convertible Debt round documented in this way (e.g. apply discount to get post-money of Convertible Debt round). And it would be a case of the "tail wagging the dog": overriding the pre-agreed legal framework so that the maths is neat... So we wouldn't suggest you do this

Modelling using Reportally: 

At present, Reportally's Cap Table builder uses the Founder Friendly version of the Convertible Debt Shuffle. Although we will shortly be releasing an update which let's you decide which conversion method you would like to use


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