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High Caps, Low Caps, and No Caps

calculateEarly-stage investing is always about striking a balance between risk and reward for both the founders and the investors. When it comes to early-stage convertible notes, valuation caps are an important part of that balancing act.

A convertible note is a loan that converts to equity in the next qualified equity financing round. These notes typically have features such as a valuation cap, a discount, or both – and either of them can affect the price at which the note converts to equity. You can think of the valuation cap as the highest valuation at which an investor’s shares will convert.

When you’re dealing with a valuation cap, as Bryce Roberts has pointed out, it’s important to remember that a cap is not a valuation and shouldn’t be perceived as one. His message to founders who are raising funds through convertible notes is that caps should be considered aspirational, and that it’s not the end of the world if you don’t exceed the cap during your next round of funding.

This distinction between cap and valuation is also an important point for investors. If you treat the cap as a valuation, you may find yourself balking at certain investment opportunities that would otherwise be a great fit for your portfolio. But if you keep in mind that valuation caps are aspirational, you won’t let a reasonable cap keep you out of an opportunity you would otherwise invest in.

Early investors do stand to benefit most if the startup’s next round of funding exceeds the cap. But between a cap that’s too high to be achieved and a cap that’s too low to be meaningful, there’s a sweet spot to be found. Bear in mind that many of today’s new companies can easily warrant a valuation cap of between $4 million and $8 million. And depending on the stage of the business, its operating history, and its previous valuations, the founders may be able to justify a cap that is significantly higher than that.

Thinking about investing in a seed convertible note with no cap at all? Think twice. Seed investors take significant risk and should be rewarded accordingly if the company does well, especially if the next round of funding is a long time in coming. Why invest at the earliest and riskiest stage when the benefits are essentially the same as for later investors?

The valuation cap is just one variable in a convertible note, but it’s one that can have a significant impact on founders and investors alike. Taking the time to understand this important number can help you make more informed investment decisions.

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