analyzing-convertible-instrument-terms

# Analyzing Convertible Instrument Terms ## When To Use - Reviewing a SAFE, convertible note, or KISS before a founder signs or an investor commits - Comparing multiple convertible instruments across a cap table to assess aggregate dilution - Modeling conversion outcomes at various pre-money valuations for an upcoming priced round - Evaluating whether MFN provisions or pro-rata rights create conflicts across investor cohorts - Advising on whether a valuation cap, discount rate, or hybrid structure best fits the deal context ## Inputs To Gather - **Instrument documents**: Full text of each SAFE, convertible note, or KISS (identify version — e.g., YC post-money SAFE 2018 vs. 2023 template) - **Instrument type and variant**: Pre-money SAFE, post-money SAFE, convertible note (secured/unsecured), KISS (debt/equity variant) - **Economic terms**: Valuation cap, discount rate (or both), interest rate and accrual method (notes only), maturity date (notes only) - **Key provisions**: MFN clause scope, pro-rata rights, amendment/waiver thresholds, dissolution/liquidation waterfall priority - **Cap table context**: Current outstanding shares, option pool size, any prior convertible instruments outstanding - **Anticipated round terms** (if available): Expected pre-money valuation, round size, lead investor terms ## Workflow 1. **Classify each instrument** - Identify instrument type (post-money SAFE, pre-money SAFE, convertible note, KISS debt, KISS equity) - Note the template version and any custom modifications from standard forms - Flag if the instrument is a non-standard or bespoke structure 2. **Extract and tabulate economic terms** - For each instrument, record: investment amount, valuation cap, discount rate, interest rate, maturity date, and MFN status - For convertible notes: confirm whether interest is simple or compound, accrual frequency, and whether interest converts or is repaid [VERIFY: confirm accrual terms in instrument] - Identify whether the cap is pre-money or post-money — this fundamentally changes dilution math 3. **Analyze conversion mechanics** - **Cap conversion**: Shares = Investment ÷ (Cap ÷ fully-diluted capitalization at conversion) - **Discount conversion**: Shares = Investment ÷ (Price per share × (1 − discount rate)) - **Hybrid (cap + discount)**: Investor receives the more favorable of cap-based or discount-based conversion - For post-money SAFEs: the investor's ownership percentage is fixed (Investment ÷ Cap), and dilution falls on founders and prior investors — not SAFE holders - For notes with accrued interest: calculate total converting principal + interest at expected conversion date 4. **Model conversion scenarios** - Run conversion at 2–3 representative pre-money valuations (e.g., $5M, $10M, $20M or as contextually appropriate) - Show resulting ownership percentages for each investor and for founders post-conversion - Identify the valuation at which the cap vs. discount "crossover" occurs (discount becomes more favorable than cap) - For stacked instruments: model aggregate dilution from all converting instruments simultaneously 5. **Evaluate protective and structural provisions** - MFN: Does it apply only to future SAFEs, or also to future convertible notes? Does it auto-trigger or require election? What is the notification mechanism? - Pro-rata rights: side letter or built into the instrument? Based on pre- or post-conversion ownership? - Amendment provisions: majority-in-interest threshold — by dollar amount or by holder count? - Dissolution/wind-down: payment priority relative to other instruments and equity holders [VERIFY: confirm liquidation waterfall ordering if multiple instrument types] 6. **Identify risks and flag issues** - Stacking risk: total SAFE/note overhang as a percentage of anticipated post-money valuation - MFN conflicts: later instruments with better terms triggering MFN for earlier holders, compounding dilution - Maturity risk (notes): what happens at maturity — auto-convert, founder repayment obligation, or default? - Shadow preferred: SAFEs converting into a separate series with different rights than the lead investor's preferred stock ## Output Structure the analysis report as follows: - **Instrument Summary Table**: One row per instrument — type, date, amount, cap, discount, interest rate, maturity, MFN status - **Conversion Modeling**: Scenario table showing shares issued and ownership percentages at 2–3 valuations - **Cap vs. Discount Crossover**: The pre-money valuation at which each instrument's discount becomes more favorable than its cap - **Aggregate Dilution Impact**: Total founder dilution from all converting instruments at the most likely round valuation - **Provision Comparison**: Side-by-side comparison of MFN scope, pro-rata rights, amendment thresholds, and dissolution treatment - **Risk Flags**: Bullet list of material risks (stacking, MFN cascades, maturity exposure, structural conflicts) - **Recommendations**: Specific, actionable guidance — e.g., "Negotiate removal of MFN from Investor B's SAFE before closing Investor C" or "Cap total convertible overhang at 25% of anticipated post-money" ## Quality Checks - Confirm whether each instrument uses pre-money or post-money cap mechanics — misclassifying this produces materially wrong dilution figures - Verify that conversion math uses the correct fully-diluted share count (including or excluding the option pool, depending on instrument terms) [VERIFY: check instrument definition of "Company Capitalization" or equivalent] - Cross-check that MFN analysis accounts for all outstanding instruments, not just the one under review - Ensure interest accrual calculations on notes match the stated accrual method and compounding frequency - Validate that scenario modeling uses consistent assumptions across all instruments (same pre-money, same option pool treatment) - Flag any instrument that deviates from standard YC SAFE / 500 Startups KISS templates and note the specific deviations