SAFE/CCPS conversion price: the valuation traps inside convertible instruments

Convertible instruments — SAFEs in the US idiom, compulsorily convertible preference shares (CCPS) and compulsorily convertible debentures (CCDs) in the Indian framework — solve a real problem. They let an investor put money in now and defer the valuation conversation until the next priced round. Founders like them because they avoid setting a number too early. Investors like them because they get downside protection through the cap and the discount.

What the standard one-page term sheet does not surface is how the conversion math behaves when actual numbers are plugged in. We have rebuilt cap tables for clients three years after the original convertible was issued and watched the founder discover that the CCPS converted at a price that diluted them by 200-400 basis points more than they expected. The math is not complicated. It is just unfamiliar.

The standard instrument

An Indian early-stage convertible typically has three economic terms.

Investment amount. The rupees written into the cheque. Suppose Rs. 4 crore.

Valuation cap. The maximum pre-money valuation at which the convertible will convert. Suppose Rs. 40 crore. If the next priced round comes in below Rs. 40 crore, the convertible converts at the priced-round price (or with the discount, whichever is lower). If the next priced round comes in above Rs. 40 crore, the convertible still converts as if the pre-money were Rs. 40 crore.

Discount. A percentage off the next priced-round share price. Suppose 20 percent. If the next priced round prices shares at Rs. 100 each, the convertible converts at Rs. 80.

The conversion price is the lower of (a) the share price implied by the valuation cap, and (b) the discounted next-round share price.

Worked example: next round at Rs. 120 crore pre-money

Suppose the company raises a priced Series A at Rs. 120 crore pre-money. The Series A investor puts in Rs. 30 crore for a 20 percent post-money stake. The fully-diluted share count before the Series A is, say, 10,000,000 shares. The Series A price per share is therefore Rs. 1,200 (Rs. 120 crore pre-money divided by 10,000,000 shares).

The convertible holder now has to determine the conversion price.

Cap-based price. The cap is Rs. 40 crore. Dividing by the same 10,000,000 share count gives a cap-based conversion price of Rs. 400 per share.

Discount-based price. Twenty percent off Rs. 1,200 is Rs. 960 per share.

The convertible converts at the lower of the two: Rs. 400. The convertible holder receives Rs. 4 crore divided by Rs. 400, or 1,000,000 shares.

Trap one: pre-money cap versus post-money cap

The example above assumes the cap applies on a pre-money basis to the next round's price per share. Many Indian convertibles use a post-money cap instead.

Under a post-money cap, the convertible's percentage ownership is fixed in absolute terms. The Rs. 4 crore at a Rs. 40 crore post-money cap means the convertible holder gets 10 percent of the company post-conversion, regardless of the next round's valuation. Under a pre-money cap, the convertible's share count is fixed in absolute terms, and the percentage ownership changes depending on how much is raised in the next round.

The difference is material. In the example above, with a pre-money cap, the convertible holder gets 1,000,000 shares in a post-Series-A cap table of, say, 12,500,000 shares: 8 percent ownership. With a post-money cap of Rs. 40 crore on the same Rs. 4 crore, the holder gets 10 percent — 1,388,000 shares — which is 200 basis points more.

The drafting of the term sheet matters more than the headline number. A 'Rs. 40 crore cap' is not a single concept. Confirm which type of cap, and run the conversion math both ways before signing.

Trap two: the share count denominator

The conversion price implied by the cap depends entirely on the share count used in the denominator. Whether the cap-implied share price is Rs. 400 or Rs. 360 or Rs. 440 turns on whether the share count is calculated on a fully-diluted basis including the ESOP pool, including unexercised warrants, including outstanding CCPS from prior rounds, or on a more restricted basis.

We have seen term sheets that say 'valuation cap of Rs. 40 crore' without defining the share-count basis. Eighteen months later, when the conversion is being calculated, there is a fight between the convertible holder and the company about whether the ESOP pool counts. The outcome of that fight changes the conversion share count by 10-20 percent.

The fix is one sentence in the term sheet: 'For the purpose of calculating the cap-implied share price, the fully-diluted share count shall include all issued and outstanding shares, all options reserved or granted under the ESOP plan, all warrants outstanding, and all convertible securities on an as-converted basis.' Make it explicit at the term-sheet stage.

Trap three: the priority of cap versus discount in down-round scenarios

The standard formulation says the conversion price is the lower of the cap-implied price and the discount-implied price. This works cleanly when the next round is at a higher valuation than the cap. It can produce surprising results when the next round is at a lower valuation.

Suppose the priced next round comes in at Rs. 35 crore pre-money — below the Rs. 40 crore cap. The cap-implied price (Rs. 400 per share at the original 10,000,000 share count) is now higher than the priced-round price (Rs. 350 per share). The discount-implied price (Rs. 280 per share, 20 percent off Rs. 350) is lower still.

If the term sheet says 'the conversion price is the lower of cap-implied and discount-implied,' the convertible converts at Rs. 280 — even though the priced round is at Rs. 350. The discount applies regardless of whether the priced round is above or below the cap.

This is usually not what either party expected. The original purpose of the discount was to give the convertible holder a small reward for taking early risk in a normal-or-up scenario. In a down round, the priced-round investor is already paying a low price, and applying an additional discount on top of that produces a conversion at an aggressive price below market.

The fix is a 'priced round price floor' clause: the conversion price shall not be below the priced-round price in any scenario. We include this in most convertibles we structure on the company side.

What founders should model before signing

Before signing a convertible, build three conversion scenarios.

Scenario one: next round at 2x the cap. This tests the typical 'normal' outcome. The convertible should convert at the cap-implied price.

Scenario two: next round at the cap. This tests the boundary case. The cap-implied price and the discount-implied price should produce similar share counts.

Scenario three: next round at half the cap. This tests the down-round case. The conversion price should not be aggressive enough to dilute the priced-round investor or the founders excessively.

If the three scenarios produce defensible outcomes, the term sheet is reasonable. If any of the three produces a conversion that looks abusive to one of the parties, renegotiate before signing.

The instrument is fine; the drafting is the problem

Convertible instruments do what they are designed to do: defer the valuation conversation, give the investor downside protection, and give the founder time to grow into a defensible priced round. The economic logic is sound.

Every conversion-price surprise we have seen has come from drafting that left a mechanical question unanswered. The term sheet is signed in a hurry. The conversion math is not run through worked examples. Three years later, the math becomes a fight. The fix is to spend two hours at the term-sheet stage running the conversion math through three scenarios and ironing out the ambiguities. The drafting time is cheap. The retroactive renegotiation is not.