What is the economic difference between a conversion discount and warrant coverage for a convertible note?

June 22, 2007

The advantages of a conversion discount versus warrant coverage depend on math and modeling.

In the example of 20% conversion discount versus 25% warrant coverage, the formulas below apply.

The value of investment with the 20% conversion discount = {[Investment amount] / [0.8 * Series A price]} * [exit value of Series A]

In other words, the above formula represents: how many shares of Series A do you get after the discount * the exit value of Series A per share.

The value of the investment with 25% warrant coverage = {[Investment amount / Series A price] * [0.25] * [exit value of Series A - Series A warrant exercise price]} + {[Investment amount / Series A price] * [exit value of Series A]}

In other words, the above formula represents: the exit value of the Series A warrant shares (taking into account the warrant exercise price) + the exit value of the Series A shares issued upon conversion of the note.

If Series A price (and Series A warrant exercise price) = $1.00, then the 20% conversion discount will always be slightly more valuable than 25% warrant coverage. (This is simple algebra to solve for the above equation.)

There is a reason why I think corporate attorneys need strong math skills. I hope someone will check the above math and concur or correct me.

Comments

  • http://www.5o9inc.com Peter Cranstone

    Yokum,

    How do you determine the exit price of the Series A in the above example. Let’s say that the investment amount is $200,000 @ a $2 price… what’s the exit value? Is it still $2

    Thanks,

    Peter

  • http://www.startupcompanylawyer.com Yokum

    By exit value of Series A, I mean the value per share of the Series A at the liquidity event.

  • Giggles

    Yokum,

    Thank you for the great blog. I was looking for information on convertible notes and got here.

    Because you asked, here is my feedback. I concur with you except, to be unnecessarily very precise,

    [exit value of Series A - Series A warrant exercise price]

    should be

    max{[exit value of Series A - Series A warrant exercise price],0}.

  • http://www.startupcompanylawyer.com Yokum

    I’m glad that someone actually read the formulas.

  • Giggles

    Yokum,
    I am a finance prof teaching how to value these financial instruments and therefore need precise formulas. Your blog is helpful! My students are very keen on knowing how to value complex deals involving, warrant, convertibles, multiple liq. pref., participation, etc. Whether students like to read formulas is a separate issue, though.
    G.

  • Gaggles

    Yokum,

    Thanks for the math, this is a very useful resource for entrepreneurs. As a seasoned entrepreneur the only comment I have is that in my experience top tier investors do not want to have warrants for Series A shares outstanding as a Series B and a Series C etc… get layered on over time.

  • Greeno

    Yokum,

    Thanks for the helpful info and great discussion. I’m wondering if “Prof Giggles” can point me in the direction of a good text or source for digging in to these formulas and hopefully studying this a little more on my own.

    Thanks again.

  • http://www.mixtt.com Eve

    Hi Yokum,

    Thanks for this extremely helpful and clear post. Could you please also explain the practical difference between a conversion discount and interest for a convertible note?

    Best,
    Eve

  • http://www.startupcompanylawyer.com Yokum

    Interest is calculated based on time the loan is outstanding. Conversion price discounts often are not linked to time, and are often fixed percentage discounts. Economically, they are quite similar, especially if interest also converts upon a financing.

  • Manu

    What are the pros and cons of using a discount vs. warrants?

    To me a discount just looks simpler and cleaner than warrants that are hanging around to complicate the cap table at some point in the future. Thoughts?

  • http://www.startupcompanylawyer.com Yokum

    @Manu – I personally prefer a conversion discount as it is cleaner (meaning there is no warrant overhang to worry about).

  • http://www.casquewines.com/ Mark B

    I have a company that I have been providing services to over several years to help it get started. I also own the company that has been receiving these services, but have never issue stock or debt on the balance sheet. I am about to go out for my first small round of funding (probably convertible notes), and want to issue a convertible note to my company that has been providing the services? Is this the best way to do this? I don't want to run afoul of tax laws, or from your advice, dept of corporations in CA. Both companies are CA corps.

  • http://www.startupcompanylawyer.com Yokum

    @Mark B – Please go check with tax advisors. The issuance of the convertible note is likely income to the receiver. I'd probably paper it as a loan.

  • prasad

    Hi Yokum,

    if we go down the path of discount rather than warrant, will end up with additional shares at the point of conversion. Are those considered the same series of stock or would there have to be a different series given the price difference. Or should this be pretty straightforward?

  • http://www.startupcompanylawyer.com Yokum

    @prasad – same series.

  • http://www.startupcompanylawyer.com Yokum

    @prasad – same series.

  • dane

    Is there any reason you can't get a discount on the exercise price of the warrents, say 20%?

    The value of the investment with 25% warrant coverage and a 20% conversion discount on the warrents = {[Investment amount / (0.8 * Series A price)] * [0.25] * [exit value of Series A - Series A warrant exercise price * (0.80)]} + {[Investment amount / Series A price] * [exit value of Series A]}

  • http://www.startupcompanylawyer.com Yokum

    @dane – the warrant exercise price could be a discount to the Series A price per share.

  • Greg

    Is “exit value of Series A” the same as “Series A post-money valuation”? For instance, if the Series A VC invests $2mm on a $6mm pre-money valuation, then (regardless of the convertible note amount) the post-money valuation = “exit value of Series A” = $8mm, correct?

  • http://www.startupcompanylawyer.com Yokum

    No. See answer above in the comments.