In a previous article I explained what convertible notes are and when they are commonly used (see article titled Convertible Note Basics). Now I’d like to dive into one of the most controversial terms in many convertible notes – the valuation cap (aka – “the cap”). I say “controversial” in the context of leading to debate/negotiation between the startup and the investors. Rarely is the interest rate or term length debated. But a cap always seems to get attention. You’ll want to understand the basics about caps before reading the rest of this article (see article titled Convertible Note Basics).
Some convertible notes don’t have a cap at all, which means the sky is the limit on future valuation when the note converts. Startups that are super hot and have a lot of demand for their investment round might be able to get away with this. But that’s the exception, not the rule. So how should you set your cap amount? The answer involves much more art than science because the real answer is, whatever you are able to convince enough investors to agree to.
Similar to selling a house, you can fixate on what the appraisals and marketing reports suggest but the truth is that your house is worth whatever the highest bidder is willing to pay for it. So let’s look at the issue of a convertible note cap through the eyes of the two stakeholders:
The investor wants the cap to be as low as possible so that their investment converts to as much equity in the future as possible. Deep down inside most know the cap is in place to protect them on the high side, should the startup grow like a rocket ship with their investment. But they also assign some possibility that their note will convert to equity at the cap amount and they have to be comfortable with that.
In order to argue for a lower cap, the investor might tell you there’s no way your company is worth that much today. In other words, they are trying to have the cap reflect your hypothetical valuation today, even though you’re not raising an equity-based round (aka – “a priced round”) today.
You’d love it if you didn’t have to include a cap at all so that you have the possibility of driving a high future valuation and minimizing dilution for yourself and your co-founders. But since your deal isn’t so hot that investors are giving you blank checks and begging to get into your deal, you have no choice but to include a valuation cap. And maybe you just fundamentally feel it’s fair to include one.
You see the cap as a worst case protection mechanism for the convertible note investor. In other words, if their investment allows you to grow like a rocket ship and reach a crazy high valuation for the future equity round that triggers the conversion to equity, the early investor absolutely deserves some protection and economic reward.
Even though I’m an angel investor, I see the cap more as a protection mechanism rather than an attempt to suggest current valuation. There’s some decent chance that the startup raises their future equity round at a valuation lower than the cap or just slightly higher than the cap, in which case the discount comes into play and the cap doesn’t.
In fact, there’s even higher chances the startup never makes it to an equity round. I personally assume there are equal odds that the note will convert at the cap versus some other valuation that is lower than the cap, which means I do have to be comfortable with the possibility of converting at the cap amount.
The other thing investors commonly forget in the debate is their discount. The discount means the future valuation can be higher than the cap and the investor will still convert at a valuation that’s lower than the cap. Let’s look at a convertible note example with a $4M cap and a 20% discount. In this case, the investor only gets to take advantage of the cap if the company raises their future equity round at a valuation higher than $5M (20% discount off $5M = $4M). So any valuation lower than $5M gives the investor exactly the same equity as if the note didn’t have a cap at all.
In case that is confusing, let me explain it a different way. Many entrepreneurs think that a $4M cap means that any negotiated pre-money valuation higher than $4M results in the cap coming into play. But because of the 20% discount, the cap doesn’t come into play until the discounted amount exceeds the cap. In this example, that means the future valuation must exceed $5M before the cap comes into play. That’s because any valuation lower than $5M gets discounted 20% to a number that is lower than the $4M cap.
This is so important to understand that I want to summarize using the above example:
- Future valuation less than the $4M cap = discount comes into play
- Future valuation equal to the $4M cap = discount comes into play
- Future valuation between $4-5M = discount comes into play
- Future valuation greater than $5M = valuation cap comes into play
Having said all this and as I’ve mentioned before, most investors will mentally evaluate the likelihood that their investment converts at the valuation cap amount because it has probably happened to them more than once before. So getting push-back from an investor could simply be due to them playing out various scenarios in their mind and applying odds to each scenario. In order for them to invest, they must be comfortable with the possibility of converting to equity at the cap amount.
How to Best Respond to Pushback?
So now let’s get really specific. A prospective investor says to you, “There’s no way your company is worth $4M today. Your valuation cap needs to be lower.” Assuming you’ve gotten enough traction and other business plan dots connected to justify a cap in this range, here’s a possible response:
“We put the $4M cap in the convertible note to protect our early investors in the event their investment allows us to skyrocket and raise an equity round in the future at a high valuation. But remember that with your 20% discount, a $4M valuation in the future would allow you to convert into equity at a $3.2M valuation. We would actually need to reach a valuation higher than $5M before this cap even becomes a factor.”
Before covering additional negotiating options, I need to say that if most investors are telling you that your valuation cap is too high, then it probably is. You don’t want to get into endless and repeated arguments over this term because if that’s the scenario you are in, your terms are not attractive enough and you are putting your funding round in jeopardy or at least causing it to unnecessarily drag out (see related article titled “Your Most Valuable Resource“).
Before proceeding forward with possible adjustments to your convertible note terms to hopefully get a deal closed, I highly recommend you read my article titled “Negotiating Valuation with Investors” because it demystifies the typical process investors go through to establish valuation in the first place and also provides some negotiating approaches to try before agreeing to adjust your terms.
If you are getting a lot of push back on the cap and absolutely don’t want to change it, take a look at the other terms of your convertible note and consider making them favorable enough to enter into your dialog. As described in my article titled Convertible Note Basics, a convertible note has 5-6 key terms that all blend together to represent the investment opportunity. And to better understand the general trade-offs between price and terms, see my article appropriately titled “Tell Me Your Price and I’ll Tell You My Terms“.
- Discount – The higher than discount, the higher the breakeven point is for your investor above the stated cap (referring to my math example above). 15% discounts are still seen occasionally but 20% is so common now that it’s probably hard to claim that it’s on the high side. Consider offering a higher discount if the valuation cap is so critical to you.
- Term – The shorter the term, the less runway your rocket ship has to fly before converting to equity. If you feel certain you will be able to raise an equity round in less than 1 year, then consider a 12 month term instead of an 18-24 month term and remind the investor of this. But also realize that reaching the maturity date without a natural conversion can be a real headache. What do the terms of your convertible note say will happen? Sometimes there’s a conversion option at a discount from the valuation cap. Or maybe you’ll need to pursue a maturity date extension (see related article titled “Extending Your Convertible Note“). I don’t recommend setting a short term just to get around a disagreement about the valuation cap.
- Qualifying Transaction – The smaller the amount needed to create a qualifying transaction the higher the odds the note will convert to equity in a shorter period of time. For example, if your qualifying transaction is set at $2M, you could raise any amount less than that on a future convertible note and your original note investors don’t automatically get to convert to equity. In the meantime, assuming your business is going well your implied valuation keeps rising.
- Change of Control (aka – Early Exit) – In the event you decide to accept an acquisition offer before the note converts, consider offering the investors a choice of either getting a 2X multiple on their principal or converting to equity at the cap amount immediately prior to the acquisition, whichever is better for them.
With all of this said, raising money is a negotiation. And just like my example of selling a house, your company will only be able to raise money using whatever terms enough investors will agree to.
Realize that setting the cap way too low, even for just a subset of your seed investors, can cause big issues upon conversion to equity. When I say “way too low”, I mean a cap that could be 1/3 (or less) compared to the future pre-money valuation of your priced/equity round (for example, a $1M cap versus a future $3M pre-money valuation). The investors with the extremely low cap will get so much equity that the new lead investor for the priced/equity round might not be able to reach their required equity amount.
Forecasting the Future Cap Table
I have a mantra that recommends entrepreneurs optimize for growth, not dilution. However, because of the various scenarios that might cause the valuation cap to come into play, I do recommend using a cap table calculator to run various scenarios and forecast what the post-Series A cap table and various equity positions would look like after the convertible notes convert to equity. You can find a link to one on my Resources Page.
If you’re struggling to convince investors to write checks, check out these related articles: