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With valuations in venture capital financings at historically high levels, companies are finding that “valuation caps” and other related terms in convertible notes and other convertible instruments are having a significant effect on company capitalization. For example, if entrepreneurs and investors do not consider the effects of outstanding convertible notes when negotiating the terms of an equity financing, there can be a disconnect between the pre-money valuation of the company and the post-financing ownership percentages. So how do convertible notes factor into a company’s capitalization in a financing, and how can entrepreneurs and investors understand and address these effects early on to avoid unpleasant surprises?

Typically, the post-money valuation for a financing is the sum of the pre-money valuation plus the amount of new money coming in. For example, if a company owned 100% by its founders receives a pre-money valuation of $10 million, and investors put in $5 million, then the post-money valuation would be $15 million. In this scenario, the investors would own 33.33% of the company on a post-money basis (i.e. $5 million divided by $15 million), leaving 66.67% for the founders.  But the existence of convertible notes can complicate this calculation.

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