editione1.1.4
Updated September 15, 2023You’re reading an excerpt of The Holloway Guide to Raising Venture Capital, a book by Andy Sparks and over 55 other contributors. A current and comprehensive resource for entrepreneurs, with technical detail, practical knowledge, real-world scenarios, and pitfalls to avoid. Purchase the book to support the author and the ad-free Holloway reading experience. You get instant digital access, over 770 links and references, commentary and future updates, and a high-quality PDF download.
The elements of convertible debt and convertible equity that we list here, including amount and interest, most favored nation clause, the valuation cap, and discount, are all terms that will come up in your term sheet if your company uses one of these financing structures. As with any financing structure, you will also negotiate legal fees as part of the term sheet.
If you choose to make a deal on a convertible note, you’ll be negotiating an interest percentage on the loan, which will accrue between the time the loan is issued by the investor and the time it converts.
Definition Interest is a type of fee that a borrower must pay their lender on top of repaying the loan itself, and it is calculated on a regular basis as a percentage of a loan. Interest motivates lenders to lend their money rather than use it in some other way and protects them from the risk that their loan may not be paid back under the agreed terms. Interest is often casually referred to as the “cost of borrowing money,”* although technically the cost of borrowing also includes any applicable fees.*
Interest rates for loans of convertible debt are usually between 4% and 8%, though FundersClub reports rates can go as low as 2%.*
Definition A most favored nation (MFN) clause in a convertible note or convertible equity allows the investor to exchange the terms of their convertible instrument for better terms offered in a subsequent convertible instrument. The MFN clause also requires the company to share information about subsequent convertible instruments with the investor so that the investor can compare the terms. Typically, MFN clauses last until the convertible instrument has converted into stock or otherwise been repaid.* An MFN clause is included in 500 Startups’ KISS, both the debt version and the equity version, and in one of the four safe versions.
Currently only about 10% of pre-seed convertible instruments include an MFN clause.* Because of the additional coordination that keeping the investor informed requires and the potential for giving away value down the road, agreeing to an MFN clause in a convertible instrument definitely involves trade-offs and should be done thoughtfully.
If you use a convertible instrument for your first round of financing, you will have to agree with the investor on whether to include a valuation cap and, if you are including one, what it should be. This is where things get tough.
Definition A valuation cap (or cap) is an optional element of convertible instruments that offers a price per share at conversion that is pegged to a mutually agreed upon valuation of the company. If the company’s valuation in the next priced round exceeds the valuation cap, then the price per share for the convertible instrument investors is the valuation cap divided by the fully diluted number of outstanding shares. If the valuation in the priced round is lower than the valuation cap, the convertible instrument investors pay the same price per share as the new investors. An uncapped note is a convertible note that does not have a valuation cap.
danger Be careful when setting valuation caps. First, the greater the distance between the valuation cap and a higher valuation in the next priced round, the greater the difference in prices per share for the two groups of investors. This means you may wind up giving away part of the company at a cut-rate price and dilute your ownership. However, valuation caps can pose risks for convertible instrument investors as well: The valuation cap may unintentionally limit the company’s valuation going forward by anchoring priced round investors’ expectations.* In “Just Say No to Capped Convertible Notes,” author and investor David Hornik of August Capital argues that capped notes are the investment equivalent of a coin flip in which the investor and entrepreneur have equal chances of getting a raw deal. The article is a warning to all entrepreneurs to pause and consider the disadvantages of capped convertible notes.
important When negotiating a term sheet for a convertible that does include a cap, don’t forget to discuss whether the cap is pegged to a pre-money or post-money valuation. If you are planning for a pre-money conversion, but the investor is thinking in terms of post-money, you could end up with unexpected results. As Brad Feld has noted, most convertible notes are ambiguous in this respect, which can cause significant confusion. Instruments may be left ambiguous to create space for negotiation down the road, but this should only be done carefully and intentionally, not because you forgot to specify how conversion would work.
To see how valuation caps work, consider this scenario from the perspective of the company’s first priced round (Series A):
Since the company’s Series A valuation is higher than the valuation cap, the cap comes into play. This round values the company at $2M pre-money with a price per share of $5, so there are 400K shares:*
Because the valuation cap applies, divide the valuation cap by the number of outstanding shares before the Series A investment to determine the convertible instrument investor’s price per share ( gives the adjusted price per share). In this case, that will be $2.50:
Compare this to the Series A investor’s $5 price per share.
The valuation cap also helps the convertible instrument investor claim a larger ownership percentage than the Series A investor for less money. Dividing the Series A investor’s $1M by a $5 share price, they receive 200K shares:
Dividing the convertible instrument investor’s $600K by the lower valuation cap price of $2.50 per share, they receive 240K shares:
Thus, out of a new total of 840K shares, the Series A investor gains a 23.8% ownership interest:
The convertible instrument investor gains a 28.6% interest:
Moreover, the founder has been diluted to only 47.6% ownership:
In cap table format:
| Number of Shares | % Ownership | |
|---|---|---|
| Founders | 400K | 47.6% |
| Series A Investors | 200K | 23.8% |
| Convertible Instrument Investors at Series A | 240K | 28.6% |
| 840K | 100% |
You can get a sense of the valuation cap’s effect even if you don’t know the price per share or number of shares in the Series A round. Divide the Series A valuation by the cap amount and you’ll get the value multiple at which the instrument converts with the cap:
Multiply this by the convertible instrument investment and you’ll find the amount a Series A investor would have to pay to get the same number of shares that the convertible instrument investor has paid $600K for, even if you don’t know exactly how many shares that is:
Conceptually that’s unsurprising because the Series A valuation is double the valuation cap at which the convertible instrument converts.
If the valuation cap and the Series A valuation were equal, or if the Series A valuation were lower than the valuation cap, then the convertible instrument investor and a Series A investor would pay the same price per share. But, even without the cap, the convertible instrument investor still benefits by receiving a larger ownership interest than they might otherwise have obtained. Founders and investors sometimes estimate the ownership interest expected from convertible instruments by dividing the investment amount by the valuation cap ($600K investment / $1M valuation cap = 60%). As we’ve already seen, convertible instrument investors don’t always get this much ownership (28.6% in the example above). But suppose the cap is $5M with all other terms held constant. The convertible instrument investor might expect 12% ($600K investment / $5M valuation cap), but they would get more. The founder and Series A investor would have the same number of shares, while the convertible instrument investor would have 120K shares:
Thus, the convertible instrument investor’s ownership interest would be 16.7%, rather than the 12%:
In addition to considering how much of the company you are willing to sell (and how much ownership you want to maintain), you also have to consider the market when setting a valuation cap. For a relatively unknown first-time founder raising their first round, you’re likely not going to be setting the cap for over $3M. If you’re relatively well-known, you could get a $5M–$8M cap. If you’re really well-known and investors have a lot of confidence in you based on past performances in other companies, you might be raising a priced round or uncapped note out of the gate.
Keep in mind that the valuation cap is not necessarily an expression of the valuation that the company has now or will have in the next round. Instead, it’s primarily a mechanism for offering an investor a premium on their investment, which gives them a reason to hand over their money. A lower cap can mean the difference between $100K at $0.05 per share and $100K at $0.10 per share for an investor. This is especially attractive for early-stage investors considering putting money into a relatively unproven company where the risks are greater.
In our section on price, dilution, and valuation, we showed that price per share, dilution, and valuations are really three different ways to view the same thing—the value of ownership in the company. To do so, we walked through a detailed scenario of what it means when people say things like, “A company raised $1M on a $6M post-money valuation.” Capped convertible instruments start to complicate this picture because a cap may lead to different prices per share for the convertible instrument investors and the priced round investors.
confusion Valuation caps are confusing. If you’re still not sure how they work, these three scenarios may help you understand the purpose and possible consequences of the cap:
Cap greater than subsequent valuation. While this is rare, it does happen. Consider a company that raised $1M with a $5M cap on a convertible note but is now raising $1M in equity financing on a $4M post-money valuation.
Cap less than subsequent valuation. Consider a company that raised $1M with a $5M post-money cap on a convertible note, but is now raising $3M in equity financing on a $10M post-money valuation.
Cap equal to subsequent valuation. If the cap is equal to the next round’s valuation, then the note converts into equity at exactly the price everyone expected. The investor doesn’t lose or gain money on the loan, with the exception of interest. The longer the time between the issuance of the note and the occurrence of the equity round, the more interest has accrued, and the greater the dollar amount of the loan upon conversion to equity.
To complicate matters even further, valuation caps aren’t the only option for adjusting a convertible instrument investor’s price per share in the next priced round. Convertible instruments can also include a discount, and they often employ both price adjustment mechanisms together.
Definition A discount is an optional element of convertible instruments that offers a percentage-based reduction in price per share when the instrument converts into equity in a subsequent priced round. Like a valuation cap, a discount rewards investors for taking an early risk on a company, allowing them to convert to equity at a lower price than the priced round investors pay per share. In early-stage financing, convertible notes and convertible equities often specify both a valuation cap and a discount—when the priced round occurs, the investor chooses either the cap or the discount, depending on which is more favorable.
Typical discounts for early-stage convertibles are in the range of 5–30%, which translates to paying 70–95% of the share price paid by the equity investors. A 20% flat discount appears to be industry standard (as of 2019), which applies regardless of when the note converts.* According to David Lishego, Senior Associate at Innovation Works, “some deals specify a stepped discount that increases the longer the note is outstanding, for example, 20% if the note converts within 12 months of issuance and 30% if the note converts beyond 12 months of issuance.”*
For a simplified discount example, consider a variation on the example discussed in Valuation but assume the convertible instrument is uncapped and includes a 20% discount instead:
Unless the instrument includes special conditions, the discount will apply no matter the Series A valuation amount or price per share. The convertible instrument included a 20% discount, which means the discounted price per share will be $4 while the Series A price per share is $5:
Dividing the original investment by the discounted price per share shows that the convertible instrument investor will get 150K shares for their $600K investment:
Compare this to the $750K that a Series A investor would have to pay to purchase 150K shares:
You can also get a sense of the discount’s effect even if you don’t know the Series A price per share. Simply divide 1 by 1 minus the discount and you’ll get the value multiple at which the instrument converts with the discount:
Multiply this by the convertible instrument investment and you’ll get the amount the Series A investor would have to pay to get the same number of shares that the convertible instrument investor will get from the discount:
Unfortunately, it’s not usually that simple. As we’ve mentioned, most early-stage convertible instrument financings have both a valuation cap and a discount,* so you should be familiar with the dynamics that creates.
In a subsequent priced round, the investor will choose between whichever is more financially desirable, the cap or the discount. Startup and VC lawyer Chris Harvey provides an example (originally published on Quora* and adapted for this guide) of how this works:
Here’s the equation you can use to figure out whether the valuation cap (based on a pre-money valuation) or the discount will apply:
If the pre-money valuation is greater than $X, you will apply the valuation cap. If the pre-money valuation is less than $X, you will apply the discount.
For a 20% discount, the discount rate is 80%, not 20%. In the case of a 30% discount, the discount rate would be 70%.
For notes that include both a discount and a cap, the notes will typically specify that the conversion price will be the lower of:
This means that the investor receives the better of the two possibilities—lower conversion price per share means that the note converts into more shares in the Series A.
Let’s walk through a couple of scenarios, assuming the following:
Convertible note principal amount = $100K
Series A investment = $1M
Scenario 1: $4M valuation cap, 25% discount, $7M pre-money valuation.
If the discount is 25%, the cap is $4M, and the pre-money valuation is $7M, we don’t need to know what the exact conversion price will be to know that the valuation cap will apply. How do we know that?
To show you how those numbers work, let’s assume the price per share of the Series A investors is $1.00 per share. What kind of a discount would apply to the safe holders with the numbers above?
Applying the discount, the conversion price is $0.75; but if we divide $4M (the cap) by $7M (the pre-money valuation), we get $0.57 per share. Because that number is lower than the conversion price of $0.75, the valuation cap applies, not the discount.
Scenario 2: $4M valuation cap, 25% discount, $5M pre-money valuation.
But what happens if the pre-money valuation is $5M—should the valuation cap or discount apply?
Applying the discount, the conversion price is $0.75; but if we divide $4M (the cap) by $5M (the new pre-money valuation), we get $0.80 per share, a higher number than the $0.75 conversion price. Now the discount applies, not the valuation cap, because the discount gives investors a lower per-share price.
confusion This is counter-intuitive because the pre-money valuation exceeds the cap by $1M. But unless the pre-money valuation is greater than $5.33M, the cap would not be triggered (as above, $4M divided by 75% equals $5.33M).
danger Many founders, at the time of a liquidity event, are shocked to learn that they can sell their company for millions of dollars without a penny making it into their personal bank account.
To fully understand the implications of your early-stage financing choices on valuation and dilution, it helps to play this all the way through to a liquidity event. To do so, you need to understand a few more key concepts: preference, conversion of preferred stock to common stock, and participation. We’ll lay out the most common scenario here (1X non-participating preference), and you can get the rest of the gory details in the section on term sheets.