Monday, May 20, 2013

A Case for Convertible Note Valuation Caps

A couple of weeks ago I attended an excellent Angel Education session presented by Miles and Stockbridge at Betamore sponsored by the Baltimore Angels.  Being a relatively active angel investor but still having a lot to learn, I was quite interested in the topic of ‘Convertible Notes’. 

Convertible notes are now quite common in early seed-stage angel investing.  Use of convertible notes as a tool for seed-stage financing is fairly straightforward but there are some parameters that need to be negotiated as part of the terms, including the rate, discount, term, etc.

While in my experience it is pretty straightforward to set reasonable terms for a convertible note, one that usually seems to be the biggest sticking point is whether or not to have a valuation cap and if so, at what amount?  A valuation cap essentially insures that the conversion of the note to shares on a series A funding event will occur at no more than a previously agreed-upon maximum valuation.  This is probably the most polarizing of all terms between the investor and founders.  From the investor perspective, a valuation cap essentially sets a reasonable floor on the percentage of ownership for the note holders when they are converted.  From what I heard from some of the founders present it seemed like their feeling was that a valuation cap of any kind gave too much away to the investors.

At first glance the reaction of an impartial observer might be that a valuation cap seems to be not aligned with the interests of the founders, and in an extreme case I agree this would in fact be the case.  At a minimum it seems to go against one of the main advantages of a convertible note vs. equity financing, which is that a valuation is not required.  At the session the opinion seemed to be pervasive among the founders present that the 15-20% discount given to noteholders on conversion should be sufficient incentive to invest.

As an investor I look at this a bit differently.  In the extreme, I agree that a note with a too-low cap is not aligned with the interests of the founders, just as having a too-high cap (or no cap at all) is not aligned with the interest of the investors.  I propose that a reasonable cap is to the best interest of both parties.  Here’s why.

From the perspective of a reasonable investor, a cap that is significantly too low, while it gives the angels a larger percentage of equity on conversion, could actually be a disincentive to future investors to fund the A round that will trigger the conversion itself.  This acts against the interests of both seed-stage investors and founders.  On the other hand, a cap that is too high, or nonexistent, creates a situation whereby the interests of the founders and investors to do whatever they can to increase the value of the company prior to subsequent funding rounds are not aligned.  Why should I as an early investor work to help the founder to increase the value of the company prior to the conversion when it only means that I will end up with a smaller stake? 

Fundamentally, it needs to be understood by founders that a seed-stage investment by an angel in their startup is an extremely high risk proposition.  Many if not most of these investments fail and are essentially total losses to the investor.  While 15-20% discount looks like it should be enough of an incentive to the investor, in reality it does not adequately compensate for the many investments that fail.  There must be a mechanism for the investor to share fairly in higher returns for the few companies that succeed in the early stages and a reasonable valuation cap is that mechanism.  Part of any negotiation of seed-stage convertible note investment terms should include a reasonable valuation cap that will be low enough to incentivize the investors but also high enough that the founder will be quite happy to have their A round funding exceed that valuation.