All startups likely will seek financing at some stage during their growth. Knowing what a convertible note and a convertible note cap is (and why startups should try to avoid one when possible), may be useful for entrepreneurs when considering typical early-stage options for raising capital (see 3 Most Common Seed Financing Alternatives – Weighing the Pros and Cons for more on seed financing alternatives).
An early-stage company seeking quick growth will usually need some initial capital. The amount a startup raises varies depending on the company, but typically the number is anywhere from US$250,000 to US$2 million. To finance this growth, a company can borrow the money, which they would be required to pay back at a specified interest rate at some point in the future (debt), or sell an ownership stake in the business to an investor (equity). The size of an investor’s ownership stake will depend on the amount of money invested and the valuation (price) of the business. Given the risk profile of an early-stage company, an investor is extremely unlikely to be willing to lend (in the traditional sense — i.e., with the expectation of being paid back their principal plus interest) to a startup at less than punishingly usurious interest rates (given the risk and lack of collateral). On the other hand, determining the valuation of a newly formed company can be difficult and may result in drawn-out negotiation. A startup should spend this time developing the early business instead, which benefits both investors and the founders
A convertible note is a combination of debt and equity that helps a startup raise needed capital while still being able to delay valuing the company. A convertible note holder “lends” money to a company at a specified interest rate (usually less than 10% a year), and that loan is normally due between 12-24 months from the date of issuance. If a company raises an equity round (usually from an institutional investor) during this 12-24 months, all outstanding principal and interest under the note would convert into the same shares of equity as are issued in the future priced equity round, but at a negotiated discount (typically up to 20%) to the price paid by those investors. An entrepreneur is able to avoid pricing their equity too early, waiting instead until a more appropriate time to raise money in a priced equity round. The note converts into equity in that round on the same terms as the new investors, but at a discount to reward the risk the note holder took by being an early investor. The convertible note terms described in this paragraph describe the so-called “uncapped convertible note.”
As the convertible note market developed, some investors argued that the uncapped convertible note misaligns entrepreneur and investor incentives. Investors argue that the discount fails to fully compensate an early investor for the risk they are taking at such an early stage, especially if the first priced equity round is at an unexpectedly-high valuation (which can happen in a hot market). In this case, the entrepreneur reaps most of the upside from having the time to use the investor’s money to build a more valuable business (resulting in the entrepreneur retaining a higher ownership percentage of the business when the company raises funds at the high valuation). This argument led to including a valuation cap on the conversion price of the note. For example, suppose an angel investor invests US$250,000 in a convertible note with a valuation cap of $10 million. If the company later raises money in a priced equity round at a $20 million valuation, the note will convert at a conversion price calculated off of the $10 million valuation set by the cap (instead of the higher valuation negotiated for the new investors in the priced equity round). Because of the cap, the angel investor will pay half the price (and receive double the shares) that the new investors pay for each dollar invested in the priced equity round.
Despite the logic of a cap, a cap can have unintended and potentially negative consequences. For further discussion of these issues please see Why a Valuation Cap in a Convertible Note Financing May Not Make Sense.