In a previous blog 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: