Justifying the Cap Amount in Your Convertible Note


Justifying the Cap Amount in Your Convertible Note


In a previous blog post I explained what convertible notes are and when they are commonly used (see post 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 post (see post 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 can 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:

  • Investor

    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 in order to argue for a lower cap, they 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”).

  • Startup

    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 cap.  And maybe you just fundamentally feel it’s fair to include.  But 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 causes the conversion trigger, the early investor deserves some protection.

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 does their equity round at a valuation lower than the cap.  In fact, there’s even higher chances the startup never makes it to an equity round.  The other thing investors commonly forget is their discount.  The discount means the future valuation can be higher than the cap and the investor will still convert at a lower valuation 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.

So now let’s get really specific.  A prospective investor says to you, ”There’s no way your company is worth $4M today.  Your cap needs to be lower.”  Assuming you’ve got 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.”

If you are getting a lot of push back on the cap and 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 blog post titledConvertible Note Basics, a convertible note has 5-6 key terms that all blend together to represent the investment opportunity.

  • Term – The shorter the term, the less runway your rocket ship has to fly before converting to equity.  If you feel reasonably 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.
  • 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 $1M, you could raise any amount less than that on a future convertible note and your original note investors must continue to wait before they 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.
  • 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.  You could try something clever like offering a 22% discount.

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.


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