Understanding The Valuation Cap

You’re a founder who wants to get things moving, but you need some funds. You’ve heard of some of the virtues of SAFEs and convertible notes, including eliminating the need to set a valuation (see our Convertible Debt Primer). While in days of yore it was basically the case that SAFEs and convertible notes had no discernible link to any particular valuation, those days have passed.

As businesses are able to go a lot farther with less cash, these convertible instruments are cropping up earlier and earlier, and more traditional funding is coming in at times when the business has grown considerably (often after you have product or even revenue), resulting in higher valuations than historically for a company’s first equity financing.

In response to this general trend, early investors started introducing a conversion mechanic (the so-called “cap”) designed to provide a ceiling on the price the note holders would be deemed to pay for the stock they get on conversion. For example, if your business raises a venture round at a $10 million pre-financing valuation but your notes have a $3 million cap, your note holders just got a 70% discount (yep, you read that right).

Now, some folks may think a 70% discount is an appropriate benefit for those taking the uber-early risk investing in your business when it was just you working alone at home (never mind that everyone else works from home too) with your dog as your assistant. However, absent agreement upfront, the holders of these instruments will get both a larger ownership stake for the dollars invested and a liquidation preference (what the investor gets in an M&A event before common holders get anything) that significantly exceeds the dollars invested (in our example, about 3.3x) if these notes convert in that $10 million valuation round.

You may have just muttered, “WHAT?!” The reason is that, unless you’ve negotiated something else (see below), the shares the note holders will get when these instruments convert will be the exact same type of shares your new cash investors are buying, with the same per share liquidation preference, but for which the holders paid substantially less per share. If we imagine that the new investors are paying $1/share, your note holders are paying $0.30/share, for something that has a $1/share preference value. And, if you’ve sold $500K in notes, your note holders just got 1.67 million shares and an associated $1.67 million in preference. That may sound somewhat less appropriate, now that we’ve said it out loud. Regardless of how founders “feel” about these caps, though, they have become quite common.

Well, now what? Consider with your counsel the following (we’re pretty creative, so these are just some of the items on the menu):

1. Don’t use convertibles. As one of the main “points” of doing a convertible note was to not fix a valuation in the first place, and with a cap you basically have set a valuation, go with a “Series Seed” equity deal instead. Series Seed deals can be simple to document, do not generally come with lots of control-strings attached, and will result in the investor having a liquidation preference that matches the investment. While the documentation is more extensive (read, costly) than a SAFE or a note, the certainty and tidiness are bonuses.
2. Issue the “discount shares” in common, not preferred. While it requires a small amount of additional drafting complexity , the note can convert into a combination of (a) shares of the “next round” preferred stock with liquidation preference matching dollars invested, and (b) the balance of shares in common stock .
3. Have the instrument convert into a “shadow series” of preferred stock. To avoid issues associated with issuing common stock to the investors, some companies create a series of preferred that is identical to the series issued to the new investors and votes together with that series on all matters – with one exception: the aggregate liquidation preference of the “shadow series” equals the principal amount of the note.

The approaches in #2 and #3 have some complexities and potential pitfalls (such as, if the balance shares are in common stock, whether the founders lose control of the common stock vote), most of which can be worked through and addressed with your investors and counsel.

To learn more about convertible debt, check out Frequently Asked Questions: Convertible Debt.