I’ve noticed a recent trend of angel investors demanding valuation caps on their convertible bridge loans, and I’ve received questions lately from startup and VC clients about them. So I thought this would be an opportune time to explain what all the fuss is about.
First, the basics.
A convertible note evidences a loan that typically converts automatically into equity upon the closing of a “qualified financing”, i.e., a funding round of some agreed upon minimum amount. The conversion is often “next round priced”, namely it converts into the security issued in the next round at the same pre-money valuation or, more likely, at a 10%-25% discount to the pre-money valuation of the next round.1 Next-round pricing makes sense when the company is at a very early stage and neither the company nor the angel investor has a clue as to what the company is really worth at that time. So they decide to punt to the next round when two things might happen: the company will hopefully have generated revenues or hit some other objective milestone that justifies a particular valuation, and the investors in the next round might be institutional (VC’s) who are more adept at valuing a company objectively. The discount represents the angel’s reward for the additional risk associated with investing at an earlier, more precarious point in time. Convertible notes are attractive to both sides relative to equity because they’re easier to negotiate and document (no economic, management or exit rights and no haggling over valuation).
Risk and Incentive Distortion
Next-round pricing, despite the typical conversion discount, may pose certain risks and distortions in incentives to the angel investor. Although the angel would generally like to see the company’s post-investment valuation increase, a higher valuation also means a more expensive conversion and a smaller percentage of the equity to be issued to the angel for the investment he made in the angel round. For example, if the angel invested $200,000, he would own 20% of the equity if the next round is at a $1 million post-money valuation ($200,000/$1,000,000), but only 5% of the equity if the next round is priced at $4 million ($200,000/$4,000,000). Accordingly, some believe the angel is incentivized to minimize valuation until he converts, creating an unhealthy diversion of incentives between the angel and founder. But a higher valuation also lowers the percentage of the overall equity to be issued to the VCs in the next round. So it’s difficult to generalize as to the impact of a next-round priced funding on investors and thus any incentive distortion that it poses. Each deal is affected by its own set of circumstances and the devil is really in the details.
A cap on next-round valuation for pricing the angel’s conversion is a common mechanism to minimize risk to the angel and align incentives with the entrepreneur. It basically provides that, solely for the purpose of pricing the conversion of the angel’s loan into equity and determining the number of shares to be issued to the angel, the price per share will be the lesser of the next-round’s price (or discount thereto) or the cap. This arguably aligns the interests of angel and founder: both will seek 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 funding.
Valuation caps can potentially impact the valuation of the next round, and in extreme cases can prevent a next round from happening altogether. I’ve seen some VCs view the cap on existing bridge notes as a ceiling on the next round’s price on the theory that it was the high point negotiated between the angel and entrepreneur. This might make it difficult to persuade a VC to agree on a valuation much higher than the cap. For this reason, entrepreneurs often hope to avoid disclosing the angel round terms to prospective VCs until a price has been agreed to with them. But if the cap is disproportionately low relative to the next round’s valuation, and the per share price is not carefully calculated to include the convertible note shares in the fully-diluted outstanding capitalization, the VCs will be in for a rude awakening when a large portion of the equity they thought they were getting percentage-wise ends up going instead to the angel note holder. Conversely, if the conversion shares are included in the pre-money fully-diluted shares, which is more often the case, it’s the founders who suffer disproportionate dilution from the conversion.
My preferred way of handling next round priced convertible notes is through variable discounts that increase as the next round gets further away in time from the note investment or occurs after milestones have been hit. Valuation caps on convertible notes can work, but the parties need to structure them carefully with an eye toward the next funding round. From the company’s perspective, the cap should be set sufficiently high so as to avoid a perceived benchmark. Well counseled VCs will insist that the shares issuable to the angel on conversion are included in the pre-money fully-diluted shares, resulting in the founders suffering all the dilution. Finally, the conversion terms should be disclosed as early as possible to the VCs to avoid a serious loss of confidence in the entrepreneur on the part of the VCs and possibly even cratering the deal.
1 Pre-money valuation with respect to a particular round of funding is the valuation of the company measured before the new money comes in; post-money valuation is calculated as the pre-money valuation plus the amount invested in that round.