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.
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