Convertible notes capped at a low valuation prior to Series A

August 25, 2014

Capping the conversion valuation for a convertible note investment into a new startup, prior to the first equity raise, has become more and more common over the last few years.  For instance, in the example below, a startup raising its first capital takes $500,000 at a capped valuation of $2.5 M.  The investors get the lower of a 20% discount or a share price calculated based on a the $2.5M valuation when considering conversion of all shares reserved for options, warrants, etc.  Here is the comparison of how a subsequent financing would play out in two traditional, uncapped scenarios:

cap note

In the above, the early note holders own a little less at the Series A than if they were equity investors but they got downside protection AND all the rights of being preferred stock.  Now looks at what happens when the conversion of the note is capped at $2.5M:

 

cap note 2

In the Capped Low case (above) the bridge note holder gets $2 of stock for every $1 invested.  The math is driven by the option pool inclusion in the capped note conversion calculation (I have yet to see a capped note where the option pool does not reduce the share price to note holders).

Who cares about this?  Well, it takes a small amount out of the common holder ownership but this can be important, or larger,  in some scenarios (large option pool for instance) or where there are other owners with rights that depend on this round (like a university with non-diluting shares).  The new investor (Investor 2) cares because the bridge investor often gets all the same rights (voting, liquidation preference) as the new money and yet, if the note investors are angels, they may not be in a position to keep supporting the company in future rounds  – a serious problem if the company struggles to raise money (maybe a posting on this issue later).

I get why the low valuation conversion cap agreement is struck – often the founders are frugal and don’t want to do a priced round where the legal expenses are going to be higher and the early investors see this as an ideal arrangement (low valuation AND protection against even lower pricing).   However, I can tell you that, as a Series A investor, it is difficult for me to see a note holder coming into the preferred round at half the share price when they didn’t take any of the pricing risk. And, I find that, while it might not affect my fund’s ownership, the additional equity to the note holders can negatively impact the founders and that’s something that we care about.

The bottom line is that one unexpected effect of the low cap is to depress the valuation that future, new investors are willing to pay either because of the impact on founders or just the emotional issue of another investor converting at a much lower valuation.  Given this tendency for the cap to depress subsequent valuations, early investors and founders would both be advised to consider either a priced round or a higher cap on conversion.  My opinion is that the right way to implement a cap is to set it in the range of where a Series A is expected.  For example:

 

cap note 3

 

Note that some of these concerns go away if the note holder is also the lead on the Series A financing.  In fact, I have seen it lead to a higher valuation because that’s what gets the investor to their ownership percentage target.

 

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