For background on valuation caps and why investors may ask for them see What You Need to Know about a Convertible Note Cap. In fact, some investors will argue that a cap is common in almost “all” seed financings and that they “never” invest in an uncapped note. While capped notes are popular, founders should not assume that it is inevitable to have a cap or unusual not to have one. Many companies successfully negotiate uncapped convertible notes, and there are reasons when that approach makes sense:

  • A cap may have the unintended effect of imposing a “ceiling” on or otherwise anchoring the valuation upon which a new investor might be willing to invest in the first priced equity round. It is just human nature that the cap will likely be factored into the mix when determining valuation.
  • One of the main reasons an early-stage convertible note round is attractive is for speed of execution and avoiding a premature and usually arbitrary negotiation of valuation. A valuation cap can undercut both of these advantages because at least some time will now have to be spent on determining an appropriate valuation to use for the cap and negotiating that amount.
  • If the valuation cap ends up being a de facto negotiation of what the investor thinks is the current value of the company (which often is the case) then the founder ends up with the worst of both worlds. The valuation cap in this case effectively sets a valuation for the note investment, but if the priced equity round is lower than the cap then the investor gets the advantage of that downward price adjustment. This is effectively an equity round with a full-ratchet anti-dilution adjustment (which is extremely rare). In fact, this outcome is even better for investors than a full ratchet since they get the benefit of an additional discount to the price after the full ratchet. This is not a good outcome for the founders under any scenario –upside or downside.

An uncapped note, on the other hand, might help reinforce a company’s image as a hot company with some leverage, help create momentum and attract better investors, more money and a higher valuation in the priced equity round.

Of course none of these reasons are conclusive. Ultimately, whether or not a cap is included in a convertible note financing almost always comes down to who has the most leverage in the negotiation. A hot company that has early stage investors knocking down its door likely will have greater success in negotiating for an uncapped note than a company desperately seeking funding to keep the company alive.

If a company does end up on the wrong side of the leverage equation and has to agree to a cap, then it should at the very least ensure that the negotiated cap is at a valuation higher than the company could achieve if it were to do a priced equity round instead. A cap in its purest form should be protection against an unexpected run-up in valuation in the priced round and not a negotiation of current price. The founders might also want to limit the size of the round if possible to try to reduce the negative impact the cap may have down the line.

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