Investors in Convertible Debt Should Understand the Purpose of Valuation Caps and Conversion Discounts
When raising capital, startups have two options: debt or equity. Many early-stage startups opt for convertible debt when raising a seed round or bridge round. Convertible debt, which is issued through a convertible note, can be beneficial to founders because it allows the founder to delay giving up a portion of their company and delay setting a valuation for the company while it’s still relatively young.
When investing in convertible debt, investors often rely on provisions such as valuation caps and conversion discounts to help hedge some of the risk of early investment. Here, we’ll take a look at what purpose valuation caps and conversion discounts have for investors.
How convertible notes work
A convertible note is a loan that converts to equity at a pre-determined maturity date or company milestone. This “company milestone” is often a financing event noted within the note’s investment documentation. A convertible note, sometimes referred to as simply a “note,” is debt with the potential to become equity.
Key features of the convertible notes are the valuation cap and the conversion discount. These two pieces are mechanisms that allow convertible debtholders to convert their debt positions, typically into preferred equity, at a lower company valuation than the latest round of financing. For these investors, by investing at a lower valuation, they receive equity ownership at a lower price than the current valuation.
What is a valuation cap?
A valuation cap, often referred to simply as the “cap,” is a pre-determined maximum valuation of a company at which the investor agrees to convert their shares. It basically places a limit on the maximum price at which convertible debt can become converted. Should the valuation of a startup increase significantly in the next round of financing, a valuation cap can protect the interests of early investors.
For example–imagine an investor invests in a company at a $3M cap. Later, institutional investors value the company at $6M. The valuation cap provision allows the convertible debtholder to convert their shares at the pre-agreed upon $3M valuation rate, meaning the price of the equity into which note converts is lower than that paid by the institutional investors in this scenario.
What is a conversion discount?
A conversion discount may be given to early investors to incentivize taking on the additional risk of investing in a company early. It is the discount given to investors when the convertible note converts from debt to equity. Like a valuation cap, a conversion discount offers a way to lower early investors’ conversion price.
Conversion discounts reduce the conversion price to a pre-determined percentage of the next funding round’s valuation. I.e., a convertible note with a 20% discount would enable convertible debtholders to convert their debt position to stock at 80%, effectively receiving “20% off” the new share price in the current funding round.
For example–an early investor makes a $1,000 investment with a discount rate of 20%. A subsequent investor also makes a $1,000 investment without the conversion discount. Imagine that the conversion event happens, and the next round of financing is secured with a conversion price set at $10/share. The early investor would receive 120 shares in the company, while the later investor would only receive 100 because they didn’t receive the conversion discount.
What is the purpose of valuation caps and conversion discounts?
A conversion price is typically not defined at the time of investment in a convertible debt investment. Instead, the conversion price is determined relative to the pricing of a future qualified funding round that does have a valuation. Without a valuation cap or conversion discount, the conversion price is usually set at the same price per share of the next qualified funding round. For convertible debtholders, that would mean that there’s little reward for taking on the risk of investing earlier, as the share price for both the convertible debt conversion and the most recent funding round are the same. Including valuation cap and conversion discount provisions in a convertible debt investment instrument is meant to lower the future price of equity for convertible debtholders, rewarding them for the heightened risk they took on in their early investment.
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The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.
