Convertible notes and LLC waterfalls
A convertible note is a debt instrument that can be converted into equity under specific conditions. These conditions may be time-based (Example: the expiration of a maturity date) or event-based (Example: the creation of a new investment round or a liquidity event). A convertible note can also act as a simple debt instrument where the principal plus interest is returned at maturity or during a liquidity event. The behavior of the note in the waterfall depends on the conditions established during its setup.
Different scenarios for calculating convertible notes
| Scenario | Calculation behaviour |
|---|---|
| Already converted to equity | A note converted to equity is allocated a specific number of shares in the designated class for the note holder. These shares participate in the waterfall like any other shares of the same class, with the investment return based on the share allocation and the original price per share (PPS) of the class, irrespective of the actual amount of the note (typically converted at a discounted price). |
| Not converted and no maturity settings |
A note is treated as debt if it has no maturity settings for liquidation events, and is set to convert at the next investment round and no such round occurs. The principal and accrued interest are subtracted from the enterprise value before the waterfall calculation. Example: A $1,000,000 note with 10% interest after 1 year will result in a total debt of $1,100,000. This amount is subtracted from the enterprise value before calculating the equity distribution. |
| Maturity date expired | If the note’s maturity date has expired, the waterfall will apply the maturity settings configured. This may involve returning the principal plus interest or converting the note into equity. |
| Maturity date not expired | If the maturity date hasn't yet expired, the waterfall assumes a liquidation event and applies maturity settings as if the note has reached maturity. |
| Return of principal and interest |
If the maturity or liquidation settings call for a return of principal and interest, these amounts are calculated and subtracted from the enterprise value. If a liquidation preference is included, it will multiply the principal (but not the interest). Example: A 2 x liquidation factor on a $1,000,000 note with 10% interest will result in $2,100,000 being treated as debt in the waterfall. |
| Conversion into an existing class of shares |
If maturity or liquidation settings specify conversion into an existing class, the following steps are used for the calculation:
These shares participate in the waterfall like any others in the same class, possibly resulting in returns exceeding the original note amount. |
