Since a startup’s valuation is usually an unknown, you need to make sure that you’re protected by the terms in your note. While a valuation cap is one device, there are other moving parts.
First, it’s important to understand that the general purpose of convertible notes is to reward early investors for taking an extra risk, and to provide some protection for them when valuation is ascertainable at a later time – that later time normally being the Series A round.
Your share price at the Series A stage is determined by dividing the valuation cap by the A valuation. This means that if you invested with a $2 million cap, and A investors set the price at $4 million, paying $1 per share, you would divide $4 million by $2 million and arrive at $.50 per share – effectively giving you twice as many shares as the A investors at the same price.
While a valuation cap can give you some protection by setting the maximum price that the note will convert into equity, there are other variables in play.
The discount rate is one factor that should not be overlooked. Like the valuation cap, it determines how much you’ll receive for taking an early risk. Average discount rates fall at around 20%. What this means for you in that if your convertible note provides for a 20% discount, and Series A investors land at a price of $1 per share, your equity translates to $0.80 per share, giving you more shares for the same price.
You need to ensure that your note provides you with the option to use either the valuation cap or the discount rate. These are fairly standard terms since the idea is to allow the early investor to obtain the best price for their early risk.
Typically, when you reach the A round, either the discount rate or the valuation cap will provide you with a lower share price, which is the one you want to opt for since it will give you more shares. The general rule of thumb is to aim for a high valuation cap and low discount rate.
Finally, you need to consider other factors such as the note’s maturity date and interest rate. Obtaining sound advice from a professional is the best route to ensure you’re both protected and rewarded for taking on an early risk. Please feel free to check outfor additional information about determining the appropriate valuation cap on a convertible note. I also welcome any questions you might have regarding convertible notes and valuation caps, so please message me directly if I can help.