Back in the dark ages of seed investing (say ten years ago), convertible notes were sometimes used but as often as not angel investors just invested in common stock or full blown Series A priced rounds. In recent years, convertible notes have become much more prevalent, partly due to IRS rule 409A making it more difficult to structure common stock deals and partly due to several relatively new features in convertible notes that address many of the concerns many early stage investors and startups had with “old school” convertible notes. While there are still some seed investors who want to do priced rounds, pricing a company too early has downsides for both the company and early investors so therefore convertible notes are often used.
Over the next several blog posts, I am going to write about some of these new features, including conversion caps, optional conversion features, discounts vs warrants, and the role of control provisions in notes. But I’m going to start with caps.
So what is a conversion cap? Basically, this is the maximum valuation that the note would convert at. The purpose is to protect the early investor (the noteholder) from a “runaway” valuation. Certainly makes sense from the perspective of the early investor who will say “If I take all the risk of an early investment in your company, and you use my money to create value in your business, then I want to make sure that I get compensated for my risk”. Nearly all convertible notes today use a discount (rather than warrants); a conversion cap is used in most notes, but in a few situations where the company has the negotiating leverage (ie, a “hot” company) there may not be a cap or it may be extremely high. If the conversion event (the subsequent priced preferred round) values the company below the conversion cap, then the discount comes into play. If the valuation is above the cap, then the note converts at no greater than the cap. Remember, the early investor is taking all the risk of equity, so it is reasonable for them to get some level of valuation protection.
For first time founders who are raising their first capital, a $2-3 million cap – max – is market. For proven founders who have had successful prior exits or for companies that already have significant traction, caps of $5-6 million can be acceptable. On two occasions, we have gone even higher than that. Founders often obsess over the cap, thinking that it sets a cap on their company valuation – it doesn’t. We have had several PSF notes convert where the pre money in the preferred round was the cap price (full disclosure – we have had MORE of them convert below the cap price). We also recently did an uncapped deal, but this one had a hybrid structure which set a reasonable valuation on the company.
How can you figure out what a “reasonable” cap should be? Much like the premoney valuation in a priced preferred round, this should be a negotiated value – but no one should spend too many calories on this. The practical reality is that the cap is a signaling device, but does not actually set the subsequent value of the company. A rule of thumb we use at PSF is to ask ourselves: “If the company achieves their milestones, would we be comfortable converting into priced preferred equity in say a year at this cap valuation?” If the answer is yes, then we are in the range. If not, we will probably try to get it reduced, but unlike with a priced round we will sometimes do deals at caps we think are too high assuming that they will get a future round done UNDER the cap value anyway – which has proven to be true in most cases.
One last point about caps is that unlike an actual valuation on preferred stock, you can offer different caps to different investors. Those who come in early and/or are going to add more value can get a lower cap; later investors or those who are more passive can get a higher cap. Paul Graham made a strong case that different early investors “have different values for startups, and their terms should reflect that.” Good advice.
I’ve heard some VCs say they don’t care about caps, others say they generally like them because they set more reasonable valuation expectations, and others who don’t like them because it complicates their deals. At the end of the day, they serve as signaling device, but that’s about it …. Subsequent investors are going to invest in the company at the value they think is appropriate for the company at that point in time regardless of a cap that was previously negotiated by some pre-seed investors. Bottom line, as investors who do a lot of convertible note investments, we think conversion caps are valuable but not something that should ever become a deal breaker in our deals.
Up next in this series … Optional conversion features in notes.