Capped Valuation Term in a Convertible Note
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A hot topic in the entrepreneurial investment world has been the trend of including a capped valuation as one of the terms in a convertible note. With convertible notes already being confusing enough, the inclusion of a cap adds a layer of complexity that is very likely to confuse first-time entrepreneurs, or even worse, the entrepreneur may not understand enough of the transaction’s subtleties to be confused, i.e., not knowing what they don’t know.
An investor might explain a cap as follows:
If I had my way, I’d prefer to invest in a priced round today. I understand your reluctance to price the deal today because you believe you are on the cusp of doing some wonderful things that will significantly increase your company’s valuation in the next round. It is because I share your optimism and enthusiasm that I am willing to invest in a convertible note to give you that opportunity. That said, by virtue of investing now and sharing the significant risk of your venture, it’s only right that I deserve to participate in the upside if you are able to hit the ball out of the park, since it is my money that will have enabled you to do so. As such, I propose that the convertible note be capped at a $5 million valuation for the next round. As we sit here today, I think we can agree that a $5 million pre-financing value on the next round looks very attractive. By the same token, if you are able to get a higher valuation, I should reap some of the benefit of that higher valuation. I shouldn’t be penalized for having contributed to the company’s success and have to pay that higher price with my modest discount. That’s not fair.
The logic can be pretty persuasive. A first-time entrepreneur may be convinced that a capped valuation is “the right thing to do.”
That may not be the case.
In the interests of clarity, two well known VC bloggers, Brad Feld and Mark Suster, and a deal attorney, have tried to explain the issues in a series of recent blogs.
The Problem in Everyone’s Capped Convertible Notes by Joe Ander, Austin Deal Attorney
One Simple Paragraph Every Entrepreneur Should Add to Their Convertible Notes by Mark Suster
The Pre-money vs. Post-money Confusion with Convertible Notes by Brad Feld
What is it Like to Negotiate a VC Round? by Mark Suster
It may be just me, but I believe that there’s a pretty straightforward way of addressing this issue and I’m actually surprised that it hasn’t been discussed elsewhere. Having been an investor for over 30 years and having taught a course, Funding Early Stage Ventures, at Carnegie Mellon University for almost as long, the first lesson I give to my students is quite simple:
Deals are negotiated with percents, but they are structured with shares. Until you’ve got a pro forma post-money cap table with the number of shares listed, you can’t possibly evaluate a proposed deal.
Shares will tell the story unambiguously. Percentages are calculated based upon the distribution of those shares. If the outcome is not what the entrepreneur anticipated, it is pretty easy to identify where and why the cap table is what it is. It is only at this point an entrepreneur can engage in a meaningful negotiation.
Originally posted on 7/30/15 to the Innovation Works blog
