Just Say No To Capped Convertible Notes!

Speaking at an angel investors conference last week I took a bold stand and begged the attendees to say no to capped convertible notes. It may seem an odd thing to take a stand against. Sure, take a stand against racism, homophobia, cilantro, but uncapped notes? What's the big deal? That may well be the very attitude that has gotten us into this mess. Capped convertible notes are a lazy solution for people who don't want to choose between debt and equity. They are the worst of both worlds. So I am taking a stand. Just say no to capped convertible notes!

Let's start with the fact that the vast majority of investors would prefer a priced equity round over a convertible note. (I'm leaving open the possibility that there are investors out there who, when given the choice, would prefer a convertible note -- but, frankly, I can't imagine who they are or why they would prefer debt to equity in an early stage startup). Equity takes the guesswork out of a financing -- X dollars invested will buy you Y percent of the company. Period. Better yet, once an angel has made an equity investment, her incentives are perfectly aligned with the entrepreneur in whom she has just invested. Entrepreneur and investor alike will strive to make the company as valuable as possible and to raise future money at a price that is significantly higher than that of the last round of financing.

Despite the certainty of equity financings, entrepreneurs often prefer to raise money with convertible notes. In a convertible note financing, the investment an angel makes in the company (technically a loan) will convert to equity in the next round of financing at the price of that round (usually minus some discount). With any luck, the entrepreneur is then able to use that money to grow his business, increasing the value of the company, and thereby decreasing the percentage of the company that the angel investor will ultimately own. Therein lies the appeal of an uncapped note to an entrepreneur -- the more progress the entrepreneur makes, the less of the company he has sold in the angel round of financing.

In light of the the disparate incentives built into these two financing vehicles, it is not surprising that entrepreneurs and investors are often at odds over how to structure an investment. But rather than debate the merits of the respective approaches and choose the vehicle that makes the most sense in the context of that particular financing, entrepreneurs and angels often "compromise" and use a hybrid of the two, the capped convertible note. The capped note converts in a future round of financing at the price of that future round, so long as that price is no higher than the specified cap. In the event that the round of financing gets done at a price higher than the cap, however, the note converts as if the financing had been priced at the established cap.

The capped note may seem reasonable enough at first blush, but the end result can have meaningful disadvantages, particularly for the entrepreneur. Capped notes are the financing equivalent of "heads you win, tails I lose." By capping a convertible note, you are saying that a financing will get done at no greater price than X. So if the company does well, the maximum price that an angel investor will pay is set. However, if the company stumbles, the investor will get the advantage of a financing price below the established cap. Given that, the entrepreneur might as well have done an equity round in the first place. At least the equity round would not have carried with it the downside risk of a capped note.

The capped note also has negative consequences in the event that a company raises money at a price significantly higher than the cap. Imagine an entrepreneur raises an angel round of $1M at a $5M cap. The least that the angel investors will ever end up owning of the company is 20% ($1M/$5M). In the event that the Series A round gets done at, say, a $20M valuation (4 times the cap), the angel investment will convert into the equivalent of $4M in Series A Preferred Stock. While that was the bargain in the angel round, it has an unintended consequence -- rather than getting $1M in liquidation preference, the angels now get $4M in preference. Again, the end product is worse for the entrepreneur than if he had simply priced the round in the first place. [1]

None of this is intended to argue the relative merits of priced rounds or uncapped convertible notes (although I am a firm believer in priced rounds). It is simply intended to point out the clear disadvantages of capped notes. Next time you are negotiating an investment in an angel round -- whether you are the financier or the entrepreneur -- don't fall back to the capped note as a supposed middle ground. It is the worst of all worlds. Just say no to capped convertible notes!

[1] There is a temptation to argue that caps on convertible notes are higher than the price at which an equity round might get done. Therefore, there is still economic advantage to a capped round over a priced round. But there is no empirical evidence to that effect. I would argue that the price an angel would pay in an equity round is indistinguishable from the price at which an entrepreneur is willing to cap a convertible note round. If that is the case, entrepreneurs should prefer equity rounds to capped notes 100% of the time.

Comments

[Greg Biggers]

Well said. At Genomera, we like the alignment (e.g. the seed investors are rooting for a high valuation at the next round, just like the entrepreneurs) that comes with a priced seed round.

Using the Series Seed standard documents (http://www.seriesseed.com) allowed us to do a priced round, with straight-up terms, for a cost similar to that of doing a convertible note.

[Rick Morrison]

There is one other big advantage for entrepreneurs of convertible notes, either capped or uncapped: they can be closed quickly. An entrepreneur can walk into a meeting with an angel and leave with the signed investment paperwork. There is no need to coordinate with lawyers or other investors.

This is both appealing and can be extremely valuable to the entrepreneur.

It prevents investors from wasting the entrepreneur's time and ultimately not committing, or having to wait for several extra weeks/months while the round is put together. The entrepreneur can get back to building their business instead of fundraising.

If a reputable angel or VC fund wants to do an equity angel round, then it makes sense. But a lot of angels are non-committal, sometimes even damagingly so. By using convertible notes, the entrepreneur can force them to decide quickly or miss out.

Valuation caps are necessary because a lot of investors don't invest in uncapped rounds. There are problems with capped notes as outlined above, but the benefits are also very appealing.

[Account Deleted]

David, I don't think I agree with this assessment assessment. As an entrepreneur I would never do a priced round if I can do a convertible note. Here is why:

1) Huge upside
- easy to close independent of other investors. Just keep signing them and with each new group of investors raising the cap. we did our round like this last year and it was much simpler than herding everyone and negotiating together
- cheap. at Ostrovok we signed 10+ different notes with different terms, and it cost us a total of less than $10k. Pretty sure that would be much more expensive with equity rounds.

2) Irrelevant downside
- if you are capable of raising a round that triggers the conversion (assuming you structured the trigger properly), you will almost never be in a situation where the cap is above the transaction valuation. You would just fail completely instead, or raise another bridge that doesn't trigger the cap.

In fact we were able to get investors on uncapped notes later in the process as well. The equity round at the sub-$1M stage is dead; the only companies that would do it are those who have no leverage. i.e. ones not worth investing in in the first place

Serge

[Nicolai Wadstrom]

My view there are a few things in favour of notes:

- If being an angel investor, irrespective of valuation and other aspects here. With a note the angel investor has the opportunity to get their initial investment converted into preferential shares, at the same terms as the VC that comes in.
- As an entrepreneur I appreciate the ability (as mentioned above by Serge), to close quickly and being able to change terms.

That said, being a European entrepreneur original (where notes are not very common), I have done equity rounds at very low cost for the company both there and here, as that is the prevailing models. Sometimes this is preferable for all parties. But I see the drawback sometimes as well, as the companies there need to do many rounds, the founders get diluted down much too quickly by number of equity rounds done. Still being in control, and able to convert at a higher valuation (even with a cap) after more proof of the startup has been created is really valuable.

[Wayne Willis]

re: your point "I would argue that the price an angel would pay in an equity round is indistinguishable from the price at which an entrepreneur is willing to cap a convertible note round." I agree totally with that. Your point reminds me of the point that the amount of seller financing carried in the sale of a business is equal to the amount the buyer overpaid.

The major negative with a priced round is the legal expense and delay, of course. Capped notes, especially for smaller amount (<$500k) make more sense, especially if you have reason the believe the Series A will be in a reasonable range -- from just below the cap to just above it.

[David Hornik]

I think that the cost differential is being overstated here. There are lots of "standard" documents out there that allow entrepreneurs and investors to make a few decisions and document the financing in a cost-effective manner.

I appreciate the speed of a note, but I also think that great companies should look for great investors and that takes some time. There's no doubt that there is value to getting back to work on your company, but spending a little extra time to find the right investors, build real relationships with them, and close the right financing is invaluable.

@Serge -- as someone who has dealt with lots of financings, both as the lawyer and the investor, the financing you describe sounds like a nightmare. Trying to reconcile alternative caps, interest accruing at different rates from different start points, etc. will assuredly add a ton of time and cost to the equity round that you ultimately do (and you probably aren't avoiding a meaningful amount of dilution in the process). I certainly hope you're right about the chances of a sub-cap round being negligible, but you never know what challenges will be thrown at you as an entrepreneur and there are plenty of instances in which great entrepreneurs have faced down rounds and powered forward to ultimately build great companies.

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In my opintion
Still being in control, and able to convert at a higher valuation (even with a cap) after more proof of the startup has been created is really valuable.

[IvanGaviria]

I have represented both companies and investors on a ton of these things over the last couple of years and have definitely come to the conclusion that if you can command a reasonable valuation (and presumably if you can attract $1M or more to a convertible debt round you probably have something people want to buy) doing the priced round can often be the better result.

Three points to add to the discussion:

On the pro convertible note side, I will say that there is one major point you left out. The "market" for convertible notes pretty consistently assumes little or no governance overhang. Often no board seats, few if any protective provisions and substantially fewer operating covenants. For many, that is a big attraction to holding off on the equity round where the control features associated with a typical venture financing seem disproportionate to the capital raised.

On the pro equity side, my experience lately has been that founders end up getting treated at Series A as if the capped note HAD been a priced round in that the Series A investor who wants 20% for their $2M doesn't want to end up at 19.2% because the notes convert at a big discount as a result of the cap. Whether the new lead pushes the extra shares into the pre-money or reduces the valuation to get to their desired result, either way the founders end up taking the dilution from the cap as if it had been a priced equity round.

Also on the pro equity side, I tend to agree that the cost differential between convertible debt and the equity round is over-stated. While it is true that if you have a group of angels in your debt round who are experienced, familiar with these terms and work together frequently it can be super efficient, I find it doesn't take much to get one of these deals off the rails and send costs rapidly upwards. I think the culprit is that the capped convertible is inherently a crystal ball exercise and so people get spun up over trying to capture corner cases with the docs (what happens if we M&A before the financing round, what about IPO, what if the valuation is $0.01 over the cap or $0.01 under, blah blah blah). Also, pretty much everyone these days has a variation of the seriesseed concept; ie., a leaner set of Series A docs that seek to be relatively standardized and can be used to crank through a deal pretty efficiently.

Lastly, just a technical point, but I think the market has sorted through the "phantom preference" issue where a big discount on a big seed round creates the perverse effect of a note holder getting Series A with an aggregate preference greatly in excess of the dollars invested. I'm seeing more and more deals where the compromise is that the note holders get the percent ownership they bargained for but convert into a Series A-1 or whatever you wish to call it that is identical in all respects to the Series A except the liquidation preference per share equals the discounted price instead of the actual price. There are also some firms whose docs provide that the shares issued to reflect the discount are common shares (again to avoid the phantom preference thing while preserving percentage ownership), but I haven't seen that approach as often.

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I will say that there is one major point you left out. The "market" for convertible notes pretty consistently assumes little or no governance overhang. Often no board seats, few if any protective provisions and substantially fewer operating covenants. For many, that is a big attraction to holding off on the equity round where the control features associated with a typical venture financing seem disproportionate to the capital raised.

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I also think that great companies should look for great investors and that takes some time. There's no doubt that there is value to getting back to work on your company, but spending a little extra time to find the right investors, build real relationships with them, and close the right financing is invaluable.

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will assuredly add a ton of time and cost to the equity round that you ultimately do (and you probably aren't avoiding a meaningful amount of dilution in the process). I certainly hope you're right about the chances of a sub-cap round being negligible, but you never know what challenges will be thrown at you as an entrepreneur and there are plenty of instances in which great entrepreneurs have faced down rounds and powered forward to ultimately build great companies.

[win]

I tend to agree that the cost differential between convertible debt and the equity round is over-stated. While it is true that if you have a group of angels in your debt round who are experienced, familiar with these terms and work together frequently it can be super efficient, I find it doesn't take much to get one of these deals off the rails and send costs rapidly upwards. I think the culprit is that the capped convertible is inherently a crystal ball exercise and so people get spun up over trying to capture corner cases with the docs (what happens if we M&A before the financing round,

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I think the market has sorted through the "phantom preference" issue where a big discount on a big seed round creates the perverse effect of a note holder getting Series A with an aggregate preference greatly in excess of the dollars invested. I'm seeing more and more deals where the compromise is that the note holders get the percent ownership they bargained for but convert into a Series A-1 or whatever you wish to call it that is identical in all respects to the Series A except the liquidation preference per share equals the discounted price instead of the actual price.

[bigj]

I find it doesn't take much to get one of these deals off the rails and send costs rapidly upwards. I think the culprit is that the capped convertible is inherently a crystal ball exercise and so people get spun up over trying to capture corner cases with the docs (what happens if we M&A before the financing round, what about IPO, what if the valuation is $0.01 over the cap or $0.01 under, blah blah blah). Also, pretty much everyone these days has a variation of the seriesseed concept; ie., a leaner set of Series A docs that seek to be relatively standardized and can be used to crank through a deal pretty efficiently.

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I appreciate the ability (as mentioned above by Serge), to close quickly and being able to change terms.

That said, being a European entrepreneur original (where notes are not very common), I have done equity rounds at very low cost for the company both there and here, as that is the prevailing models. Sometimes this is preferable for all parties.

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The argument you make exhibits the difference between traditional capital market financing and the venture capital community. At its very base, risk and return are correlated and by capping a convertible note, an investor is simply lowering his risk without the corresponding decrease in reward. Obviously a good thing for the investor, not so much for the entrepreneur who has constant risk but with a convert a diminished return.

While embedded options do impact the pricing of the security the cap feature should as well!! While in a liquid market this pricing is an easier exercise, in the venture 'market' however, the vast number of financings are not priced by any market but rather as a result of a negotiation between two parties based upon looser principles. Thus if an investor is more skilled at negotiating or just plain has the upper hand when dealing with an entrepreneur, they can impose a cap feature. At the end of the day it is up to the entrepreneur to agree to it and if they don't like it, they can go back to the venture 'market' and seek capital. What is ultimately important is that the entreprenuer actually understands the implications of a cap feature for them.

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There is one other huge advantage for entrepreneurs of convertible notes, possibly capped or uncapped: they could be closed quickly. An small business owner can stroll into a getting together with with an angel and leave using the signed expense paperwork. There is no should coordinate with lawyers or other investors.

This is equally attractive and could be extremely useful towards the entrepreneur.

It prevents traders from wasting the entrepreneur's time and ultimately not committing, or possessing to wait for several extra weeks/months while the round is suit together. The small business owner could possibly get back again to constructing their business instead than fundraising.thanks!

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