help with valuing convertible notes?

Congratulations!  You and your team just secured some money in the form of a convertible note.  For those of you who may not be familiar with this, a convertible note is a debt instrument that can be converted into stock at the option of the holder.  It’s considered debt because until the note is paid back, plus interest, or until it is converted into stock it is a liability of the company and is recorded as such on the balance sheet.

Why would you do a convertible note instead of just a loan or go the equity financing route?

Convertible notes are often used for a small first angel round ($100-500K) or an interim round (say between an A round and a B round as a bridge) to provide financing on terms that will be decided at a later date when additional parties, often professional investors in the case of angels or different/new investors in the case of the interim round, participate.  Because the convertible note is like a loan, the legal costs to go this route are much lower than a full blown financing.  As well, because of the conversion option you may be able to get an interest rate that is better than a conventional loan.

Very cool.  So, yup, we got the money so we just include it on the balance sheet as a loan, right?

Nope.  You need to classify the proceeds received from convertible debentures into their liability and equity components using the relative fair value approach.  The carrying amount of the liability component is “accreted”* over the life of the instrument through charges to operations using the effective interest rate method.  On conversion into shares, the carrying amount of the equity component and the carrying amount of the liability component are transferred to share capital.  In the event that the instrument is settled in cash, this is treated as the extinguishment of the instrument and therefore a gain or loss on the extinguishment of the liability component is recognized in the current period operations while any gain or loss on the equity component is applied to contributed surplus.

uhm, what?  How do I determine the equity portion and the debt portion to start all this accretion business against?

First, read all the convertible note terms very carefully (note face value, closing date, maturity date, debenture term in months, interest rate, and conversion price).  From here you determine the net present value of the debt portion based on the interest payments and the value of the equity portion using the Black Scholes model.  These two valuations will allow you to determine the percentage of fair value to apply to the note amount for the debt and equity components.  Finally, you can then book the initial journal entry that will debit cash and credit Convertible Note - Debt and Convertible Note - Equity.  Each month you will then book one journal entry that records the interest expense, offset to interest payable, and one entry to record the accretion expense that is offset to the Convertible Debenture - Debt.

Whoa, Nelly.  This is far too complicated.  Do you have an example?

Yes we do!  the Business Ready Convertible Notes template will help you set up the equity and debt portion easily while keeping you compliant on fair value and making your auditors prrrrrr that you have been so thorough with your set up and monthly journal entries.   Why suffer needlessly?

*“accreted” or “accretion” is a silly accounting term for “to make larger or greater, as by increased growth”.  Why must lawyers and accountants speak in a language no one else uses!?!?!