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
9 Responses to “What is the economic difference between a conversion discount and warrant coverage for a convertible note?”
Leave a comment.
-
Buy this Wordpress theme
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
By exit value of Series A, I mean the value per share of the Series A at the liquidity event.
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}.
I’m glad that someone actually read the formulas.
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.
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.
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.
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
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.