Founders and Investors Take Note:
Discounts and Caps Can Make or Break a Deal
In an effort to save time and money, investors and founders alike have made the convertible note (and its cousins, YC’s SAFE and 500 Startups’ KISS) the investment contract of choice for companies raising angel, pre-seed, seed or bridge rounds. For simplicity’s sake, I will refer to these agreements collectively as “notes.”
Almost all notes include one or both of the financial provisions known as a Discount and a Valuation Cap.
The Discount represents the percentage by which the conversion price will be lower than the price paid by new investors at the subsequent priced round. For example, if a note has a discount of 20%, and the startup subsequently raises an equity round at a $10M valuation, the note will convert at an $8M valuation. In other words, the amount of stock the noteholder gets is determined as though he or she invested at an $8M valuation.
A Valuation Cap represents a maximum valuation for the note investor during a subsequent equity round. For example, if a note has a Valuation Cap of $5M, and the company subsequently raises an equity round at a $10M valuation, the note will convert at a $5M valuation.
Most notes include both a Discount provision and a Valuation Cap provision and provide for conversion at the one that results in the lower conversion price — that is, the one that provides the greatest number of shares to the investor. At Forefront, we only invest in notes that include both a Discount and a Valuation Cap. We expect notes to convert at a discount to a subsequent equity round no matter the valuation of the future round. The Discount provides for this. But when a startup is successful, the compensation provided for by a Discount is often inadequate. That’s why we also require a Valuation Cap.
Fundamentally, we believe a Valuation Cap is a reflection of the company’s valuation at the time we invest. Startups raise capital using notes at the earliest stages to save time and money as compared with an equity round. These are standard, boilerplate documents that necessitate much less (if any) assistance from attorneys. Equity rounds, on the contrary, are accompanied by significant legal fees. Investors accommodate this shortcut, but in so doing, sacrifice certain protections they would receive in an equity round. However, they should retain the economic incentives associated with investing at the earliest stages. The Valuation Cap does this by ensuring that note investors share in the upside if the company is successful. The Discount provides some compensation in cases of an equity round that is less than or equal to the Valuation Cap. We see both provisions as essential because we believe that note investors should be fairly compensated for the investment risk they assume by investing in startups at such a speculative stage and should share in a company’s success.
Let’s look at a few examples. Assume we invest in a note with a $5M Valuation Cap and a 20% Discount. In Scenario A, the company raises an equity round at a valuation higher than the Valuation Cap. In Scenario B, the company raises at a valuation equal to or less than the Valuation Cap. In Scenario B, we can assume that the startup has not been as successful as we projected when we invested. In those instances, the Discount is sufficient compensation for the additional risk we assumed as compared to the investors in the equity round.
In Scenario A, where the valuation in the equity round is greater than the Valuation Cap, we expect to share in the upside based on the valuation (as reflected by the Valuation Cap) at the time of our investment. For example, if the round is priced at $10M, absent a Valuation Cap, our notes would convert at a valuation of $8M ($10M, less 20% Discount). This would be inequitable since the valuation at the time we invested in the notes (again, as reflected by the Valuation Cap) was $5M. The Valuation Cap ensures that our notes convert at a valuation no higher than the company’s valuation at the time we invested. This inequity is even worse when a note matures or the company is acquired prior to an equity round. An acquisition could happen at any time and the note could mature years before the company raises an equity round. In such circumstances, notes convert based on the Valuation Cap, which is arbitrary and not at all a reflection of the company’s value at the time of conversion.
Some companies (often at the behest of their attorneys or advisors) offer uncapped notes or they set the Valuation Cap based on the valuation they project in a future equity round. They may take this route because they believe that the Discount provides reasonable compensation to the note investor if the company raises an equity round at a valuation that is higher than today’s valuation. More often companies take this approach in an effort to defer the discussion of valuation with investors, preferring instead to “let the investors in the next round decide the valuation.”
Both uncapped notes and notes with Valuation Caps set based on a future projected valuation are inequitable, as they do not reflect the current valuation of the company. The risk involved with investing in a startup is significantly less in the Series A round than in the Seed round, for example. A Discount of, say, 20% does not adequately compensate the Seed investor for assuming this additional risk. We would rather invest in the Series A round at a 20% higher valuation once the company has been substantially de-risked.
Yes, setting the Valuation Cap at a company’s current valuation means finding agreement between the company and the investors on just what that value is, but doing so is in everybody’s best interest. We do not believe there is any benefit to delaying this discussion until the company raises an equity round; it’s better for both parties to be on the same page now. Setting the Valuation Cap at some arbitrary, projected future valuation also often has negative consequences for the startup.
If a company tries to peg the Valuation Cap to a future equity round valuation but ends up not meeting every one of its projected milestone, raising an equity round becomes much more difficult. Future investors will be reluctant to invest in an equity round priced below the Valuation Cap. This would be an implicit indication by the company that it did not meet its projections or that it overestimated the future value of the company. Hampering a startup’s future access to capital can be lethal and is a significant additional risk to incur.
Investors in the earliest stages of a company’s development play a vital role in the startup ecosystem. These investors must be properly incentivized to assume the outsized risks associated with investing at this stage. Notes that include both a Discount and a well-chosen Valuation Cap — one that reflects the current valuation of the company — accomplish this. Saving time and money and keeping documents simple are excellent reasons for a startup to sell notes instead of equity, but punting on the valuation discussion is not.
Phil Nadel is the Co-Founder and Managing Director of Forefront Venture Partners (www.forefrontvp.com). Follow him on Twitter: @NadelPhil or onMedium at https://medium.com/@pnadel.
