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).
This article isn’t intended to get into every detail of convertible note mechanics. But I get enough questions about when to use them and what the basic components are that I thought a basic primer was in order. I’ve also included a FAQ at the very end to help you answer common questions from investors that aren’t familiar with convertible notes. And for those interested in the seed-stage SAFE investment instrument made available by Y Combinator in December 2013, ready my review and comparison to convertible notes here.