Why we don’t invest in uncapped convertible notes

Entrepreneurs often claim their business is in a state where it’s hard to set a valuation, or where they’re going to fundraise in a short period of time and don’t want to establish a low anchor point for those negotiations. Both of these are absolutely fair. A next round investor won’t want to pay double what an investor paid a month and a half ago, and all early stage businesses are hard to price. But as with most things in life, price matters. If you walked into a store, would you ever buy an item without knowing what it costs? Probably not. If that banana costs $75 at the register, you’ll probably put it back. With uncapped notes, you can’t put it back.

So investors must find some way to solve for these problems. Business hard to value? That’s always the case — find comparables and reach a compromise that everyone can live with. For the time being, we’ll exclude insider-only bridge notes to a fundraising round within 3 months. That’s an exceptional case and each one has its own story.

But here are some reasons why most reasonable investors will not invest in an uncapped note (and yes, we know some do, even smart ones, but their incentive sets like “buying a seat at the table” often don’t reflect pure economic motivation) — even if the plan is to have the note convert at a reasonable price and discount.

1. Fund guidelines/ownership targets — most funds have a target ownership they need to obtain, or a valuation range in which they can invest. Uncapped notes could cause the fund to break its own rules, causing a problem with its LPs.
2. The idiot termsheet — maybe the company and investor agree on the valuation the company should be able to reach with current capital, and therefore the likely valuation upon conversion. But there are often scenarios where a strategic, a desperate investor, an uninformed investor or someone else offers a valuation completely divorced from market forces — we call this “the idiot termsheet” — and the note investors are stuck paying the idiot termsheet price, minus some discount.
3. The bootstrap/venture debt option — it’s entirely possible that an entrepreneur experiences strong growth after raising the note, then continues to grow without raising a priced equity round. Generally speaking, this may be a great option for both the company and the investor. But with an uncapped note, the valuation keeps rising (thanks to the capital invested!) at no benefit to the investor who enabled that growth.
4. The discount isn’t a sufficient rate of return — if a note has a 20% discount rate, and converts in 18 months, the investor has earned in the neighborhood of a 12% rate of return. Venture funds typically need 25–30% plus rates of return. This math doesn’t work. So a discount would need to be 25%+ if it converts in one year, and higher if it converts in greater than a year, in order for a discount on an uncapped note to produce the required rate of return.

So even though it may seem easier not to set a valuation today, investors have a number of rational reasons (other than the fact that most VCs are difficult, stubborn and principled) to believe that uncapped convertible notes do not align with the needed economics of their fund. If you want to raise from smart investors that focus on producing returns, you’ll need to find a way to set a mutually acceptable valuation cap that satisfies all parties.