How do you set them for a funding round?
I’ve previously written about the basics and some of the key considerations when raising using a convertible note (if you haven’t read that I’d suggest starting there). In this post I wanted to dive into probably the most negotiated term, the valuation cap. It’s a topic that’s come up a lot in discussions I’ve had with founders raising using convertibles and I thought it was worth sharing some thoughts more broadly.
Some very hot companies raise money using convertibles without a valuation cap, but in todays market (and any market) that is very rare. When thinking through how best to arrive at a fair and reasonable cap, I find it useful to consider both the startup and investor perspectives. Whilst I operate on the investor side of the table, I believe that both sides fully understanding the variables at play leads to more efficient negotiations and therefore less time spent. My goal is to help founders get back to building and spend less time negotiating with investors or worse yet…lawyers (I’m allowed to say that as I used to be one 😜).
The Startup 🚀
A key consideration from the startup perspective is what any amount raised under the note will convert into at the next round. In particular founders should be mindful of the potential dilution that they will take on conversion. A very low cap could result in a toxic cap table situation and deter the next round investors — this is a situation to be avoided at all costs. I always recommend founders consider a new convertible note in the context of the next round and model this out in their cap table to understand the potential impact.
The Investor 💰
It’s logical to think that an investor would want to set the valuation cap as low as possible. The lower the cap the potentially larger % of the company their investment will convert into at the next round. However, this approach misses the point. The valuation cap is not exactly the same as a valuation. It’s primary purpose is to protect an investor against converting to a disproportionately small % if the next round valuation is very high. As such, the cap should likely be set at a premium to achieve the desired effect. As it usually works in conjunction with a discount (see my earlier post), there’s usually a range by which an investor will get comfortable by looking at proxies for valuations of similar stage startups (at the time of investment) and what is likely an achievable valuation at the next round. Add to this an investors target ownership % (on conversion) and you can see how most investors arrive at valuation caps they believe reasonable.
An additional consideration from both startup and investor perspective, is the likely amount of time between the money raised under the convertible and the next financing round. The longer the convertible round represents in terms of runway the more the cap should likely be a proxy for valuation at the time of such convertible note investment. This is logical from a pure risk allocation perspective. If an investor can wait until the next round and get similar economics then they’re likely to do that (caveat if it’s a super hot deal and they’re worried about future access). Whereas if the convertible round in question is a short term bridge it may be more appropriate to use the potential imminent next round valuation as the number to more closely base the cap from.
Overall, setting a valuation cap is more art than science. Personally, I think the most crucial factor is ensuring that founders do not take a disproportionate amount of future dilution. After all, it’s the founders (and their team) who drive the most value creation in any startup so it’s in all stakeholders interest for them to be properly incentivised.
p.s. I’m yet to come across any good data on valuation cap ranges by stage of investment - if anyone has any I’d love to hear from you.