Convertible Debt – Valuation Caps

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.

  • Brad, what do you think of a common conversion right in lieu of a cap?  In the example above, investor can convert into common at any time at $4 mil. valuation.  He’s required to convert into the qualified financing (at $16 mil in the example), but can first convert into common at $4 million if he so chooses.  Can also convert into common in an acquisition.  I can see this being simpler and more aligning of interests in all scenarios, but am really interested in your reaction.

    • It’s an ok approach – I see it occasionally. From an investor perspective, I’ve always felt a “light preference” (e.g. liquidation preference, no participate) was fair for anyone who put money into a company. 

      This approach also creates option valuation issues (409a related), although in this example the option basis is $4m and the company valuation is $20m so the strike price for common ends up at 20% of the preferred, which is ok.

      Finally, depending on the size of the round, you might end up with a class vote issue. If you end up with $1m of invested capital that takes 20% of the common, by the time you toss in an option pool, you are pretty close to the founders having less than 50% of the common, which as a founder you’d never want.

  • JamesHRH

    Brad – my first reaction is a stacked cap. Using your numbers:
    1) 20% discount on valuation up to $5M
    2) 15% discount on valuation up to $10M
    3) 10% discount on valuation up to $20M
    4)  5%  discount on valuation of 20M+

    You could also add a timeframe, so that it became a simple bingo card. Hard to show this in a comment box!

    The assumption underlying this is that you want to reward whoever turns out to be right.

    If the entrepreneur can take your $100,000 and get a term sheet on a pre-money of $20M inside 6 months, its likely that the value of the company was a lot closer to 20M than 2M, when the seed money went in.Its not complicated and it would create clarity.

    What am I missing (my favourite assumption)?

    • Generally I see time used for the discount instead of valuation levels. This was regularly done when I made angel investments between 1994 and 1996. For example, if a preferred round was done in 30 days, there was a 10% discount, 90 days there was a 20% discount, over 90 days there was a 30% discount. For some reason this fell out of fashion in the most recent angel wave.

      Your approach is ok, but the discounts are backwards! I’d think the approach the entrepreneur would want would be a lower discount on the lower valuation (e.g. 5% on $5m) and steeper on higher valuations (20% on $20m+). However, that doesn’t really address the time issue, which is a big part of the dynamic here.

      • JamesHRH

        I had a look at the Techstar CD term sheet. Noticed ‘Bridge’ in the Title. That framing makes the time factor more pronounced.

        My take on the discounts is more of a debate. I say the company is worth $20M; you say $2M. If you are closer to being right ( I get a term sheet @ $5M ) you get a big discount; if I am right, you get a small discount.

        Regardless, I really like the Foundry approach of ‘sucking it up and setting a price’. But I wanted to investigate this – it seems to be a valid option, especially if it is a really strong angel who does not play in your space ( someone you trust, who is an experienced business builder, but not an Internet or SW pro…… ) and would be willing to let ( more comfortable if ) an Internet pro set the price.

  • Anonymous

    I’m confused!  Why would the investors valuation be $16M?  I thought that the 20% discount was off the inferred share price?

    • True – I should have been doing the math off the post vs. the pre, although it’s probably very close. Assume the company raised $5m, so the post ended up being $25m. A 20% discount would be a $20m post, or effective pre of $15m (vs. $16m).

  • Aaron

    With convertible debt does the entrepreneur sign personally? What happens to the debt in the event the company fails?

    • No – the entrepreneur should never sign personally. The debt is a responsibility of the company only.

      If the company fails, the debt is worthless (although the debt holders will be senior creditors in any recovery – the first money will go to them.)

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  • _

    Is the basis of the cap the entrepreneur’s private (meaning: unstated) valuation at the time of raising convertible debt?

    I’m planning to use convertible debt. If I was using equity instead I would ask for $2.4 million pre-money. Is that basically equivalent to zero percent discount on a $2.4 million cap? By the same logic, does that imply a 50% discount at a $4.8 million valuation in the next round?

  • Simon Waddington

    I don’t understand why a VC would agree on a price without knowing the terms of the seed round, if there is debt equity involved wouldn’t they always want to know something like that since it affects who the other major equity holders will be after the round (or am I missing something?)

    • Because it’s a relatively small investment and the VC isn’t necessarily committed to the next round. As long as there is a cap and a discount, that’s usually enough certainty given the notion that the next round will be a preferred stock.

  • BobX

    Brad, or anyone – can you explain this example (or any other) with a peak to the per share price, and the amount of shares acquired in terms of % of total shares?

    i.e this example but with a share # and the resulting end share # the convertible note holder holds at a series a valuation?

    • Just assume that ever share is $1 / share and do the math based on that (e.g. $100k investment is for 100k shares).

      • BobX

        Brad having trouble understanding the end game ownership and how this works with the total number of shares, just to make clear – say in the case of $100,000 investment with a $4 million cap and a total of 1,000,000 shares

        At Series A, the pre money valuation is $8 million, would the following be correct to say the share price seed investors receive is $0.50/share ($4m/$8m = $0.50/share) and price per share of the Series A Preferred Stock is $8/share ($8,000,000/1,000,000 shares). The seed investors’ $100,000 investment converts to 200,000 shares (100,000shares/$0.50 share) So the seed investors convert there initial $100,000 investment to 200,000 shares of 1,000,000 shares so 20% ownership at Series A?

        And if a cap of 20% was part of the convertible note, the series a per share price of $0.50 would be discounted to $0.40/share and they would convert and own 250,000 shares of 1,000,000 shares so 25% ownership?

        • You are making this much too complicated. However, to know the amount the seed investors get, you need to know how much is invested in the Series A.
          So – assume:
          1. $100k seed investment with a $4m cap
          2. $2m Series A with an $8m pre-money (post money of $10m)

          So – the seed investors get a discount of 60% off the Series A price.

          Now – assume the price per share of the Series A is $1. So there are 10m shares outstanding after the series A.

          The seed round will be priced at $0.40 / share. $100k will buy 250,000 shares. But this is of 10,000,000 shares, or 2.5%.

          • BobX

            Thanks Brad,

            p.s your book has helped

          • you should add this example to the book. This section was the only bit that confused me. This reply cleared it up.

          • Will Davies

            Hi Brad. I am in the middle of working out the conversions of my notes at the moment. Where I am getting lost is when you say “Assume that the price per share of the Series A is $1”.

            How do you get to that?

          • I made it up – it’s an assumption.

  • vcSam

    I’m confused about why the investor would want his portion valued at $4 million and not $16 million. Doesn’t $16 million give him a larger portion of the company?

    • jasonmendelson

      The $4m is the covers upon pre money. Not what the his investment is worth. Lower the conversion number, the more of the company the investor owns.

      • vcSam

        so the $4 million cap really just establishes the percentage of the company that the investor will own? If it’s above $4 million, the investor’s percentage is always 2.5%. If it’s below, then the investor’s percentage is higher?

        • jasonmendelson


  • rozlemieux

    In the case of a bridge where you don’t have a strong leader on the investor-side offering terms, how does an entrepreneur come up with a suggested cap? In our case, we know investors will want a cap on the bridge, but since each angel has only invested a small amount (e.g. $25K) they’re more likely to walk away from the bridge than negotiate if they don’t like the terms. We don’t want to negotiate against ourselves by setting a low cap, but we’re not psychic enough to know what would be considered a too-high cap by our relatively diverse set of angel investors. We’re thinking 10x revenue (at est. time of Series A closing) as a target #. (We’re tech, SaaS, B2B) Is there a rule of thumb here?

  • Olivier M

    “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”

    >> if we want to negotiate “thoughtfully”, what’s the approach for a first seed round with BAs on a very hot startup (AI fields etc) for a 500K note?
    >> if we’d go with cap, should we negotiate a 6 or 7M instead of a 3 or 4M future valuation? (envisioning Serie A within 12-18 months for instance)

    • Landing somewhere in the 3m (low) and 7m (high) is the right zone. It’ll depend on the progress you have made so far and the investors you are talking to.