We’re living at a time when valuations are very high, as Fred Wilson and Ari Newman have both recently pointed out. When valuations rise, so do the caps on notes, which are upper limits on valuation at conversion.
In many cases the caps are very high because the entrepreneurs are telling the investors that they’re super confident they’re about to raise a larger round and they just need to “bridge” the company to that larger round. The reason the entrepreneur want a high cap is to signal a high price for the next equity financing of a larger amount of money. If they accept convertible notes now at a low cap, how could they possibly justify a higher equity price in a few short months when this larger financing is bound to happen?
For example, a company may be raising $1M in notes at $15M pre-money valuation cap with a 20% discount. They’re doing this, because they’re “so close” to raising $5M in equity at $15M pre or more! Part of their story to their bridge investors might be that this $5M equity financing is imminent, and that the investors in the bridge notes are getting a discount (typically 20%) to that “just around the corner” equity round. What a deal!
But if this is a company that has limited progress and no business normally getting to a $15M pre-money valuation, it’s obviously going to be hard for investors to swallow that cap. But of course, they realize that it’s only a cap, and in actuality the next financing may happen at a lower price. So maybe the investors will consider investing anyway. And I often see them do so, and what follows is predictable. Uh oh! There is no large equity financing, and they’re now in a company with a $15m conversion cap instead of a $5M conversion cap. They assumed they company would be worth more sooner with a large influx of cash. But it’s not. Now years go by and finally the notes convert at $10M due to the eventual slow progress of the company. Great, that’s still better than $15M, but it’s twice as a bad as $5M from the investors perspective.
When I’ve faced this situation of the larger financing being “just around the corner,” I’ve used a conversion clause that says the agreed (high) cap is valid only for a year, and if there’s not a qualified financing (of, say $5M) within a year, the cap would go to a lower number that I feel is more in line with their current value. I’ve found this to be a handy solve for this situation. And, perhaps more importantly, I learn something from the negotiation.
If the entrepreneur says they’re fully confident they will raise the qualified financing within the year, then they should be more than willing to accept the reasonable but lower price in the event that they don’t!
As an investor, the red flag that I pay attention to is if the entrepreneur is hesitant to include that alternate conversion clause in the case where there is no qualified financing within the agreed timeframe. That tells me that they’re not *actually* very confident that they’re going to raise the larger equity financing, and that I should take that into account as an investor. This is one way to suss out how confident they are that they’re going to raise that higher priced equity round.
Ultimately, the terms should match the story and this is just one way to make sure that they do.
So, if you’re a founder or CEO and you believe you’re bridging to an imminent larger financing, and you find yourself wanting to “signal a high price” via the note cap, one way to make your life easier is to agree to use a lower conversion cap in the event that the financing that you expect doesn’t happen in some reasonable timeframe. It will be an easier sell to your investors. And, if you’re truly confident in the upcoming higher priced round, it doesn’t really cost you anything.
Seem reasonable to you? Have you done something similar?