Today, in our series on convertible debt, we examine the conversion valuation cap.
The cap is an investor-favorable term that puts a ceiling on the conversion price of the debt. The valuation cap is typically only seen in seed rounds where the investors are concerned that the next round of financing will be at a price that is at a valuation that wouldn’t reward them appropriately for taking a risk by investing early in the seed round.
For example, an investor wants to invest $100,000 in a company and thinks that the pre-money valuation of the company is somewhere in the $2 to $4 million dollar range. The entrepreneurs thinks their valuation should be higher. Either way, the investor and entrepreneurs agree to not deal with a valuation negotiation and consummate a convertible debt deal with a 20% discount to the next round.
Nine months pass and the company is doing well. The entrepreneurs are happy and the investor is happy. The company goes to raise a round of financing in the form of preferred stock. They receive a term sheet at $20 million pre-money valuation. In this case, the discount of 20% would result in the investor having an effective valuation of $16 million for his investment nine months ago.
One on hand the investor is happy for the entrepreneurs but is shocked by the relatively high valuation for his investment. He realized he made a bad decision by not pricing the deal initially as anything below $16 million would have been better for him. Of course, this is nowhere near the $2 to $4 million the investor was contemplating the company was worth at the time he made his convertible debt investment.
The valuation cap addresses this situation. By agreeing on a cap, the entrepreneur and investor can still defer the price discussion, but set a ceiling at which point the conversion price “caps”.
In our previous example, let’s assume that the entrepreneurs and investor agree on a $4 million cap. Since the deal has a 20% discount, any valuation up to $5 million will result in the investor getting a discount of 20%. Once the “discounted value” goes above the cap, then the cap will apply. So, in the case of the $20 million pre-money valuation, the investor will get shares at an effective price of $4 million.
In some cases, caps can impact the valuation of the next round. Some VCs will look at the cap and view it as a price ceiling to the next round price, assuming that it was the high point negotiated between the seed investors and the entrepreneurs. To mitigate this, entrepreneurs should never disclose the seed round terms until a price has been agreed to with a new VC investor.
Clearly, entrepreneurs would prefer not to have valuation caps. However, many seed investors recognize that an uncapped note has the potential to create a big risk / return disparity especially in frothy markets for early stage deals. We believe that – over the long term – caps create more alignment between entrepreneurs and seed investors as long as the price cap is thoughtfully negotiated based on the stage of the company.