What is the right cap and discount for your convertible? Should you even have them at all? The latter used to be a very rare situation, now it is a commonly asked question. This article is to help entrepreneurs make sense.
1) Key Principles
Let these serve as a reminder:
- Convertible notes are debt that eventually become equity. The two most powerful levers are cap and discount rate.
- Priced rounds are equity. Investors generally prefer priced because it gives them more certainty.
- SAFEs are a type of convertible that has become especially popular because of its simplicity.
There are plenty of examples online of how convertibles / cap / discount work, so what this article will focus on is understanding the trade-offs. The following past articles provide further relevant background:
Heads up — there is a third lever called interest. A typical scenario is 10% interest over 2 years i.e., you have to factor the cumulative interest in calculating the share price upon conversion. It rarely makes a big difference so we are simplifying the discussion below on purpose. And recently there has been a trend around pre- and pos- cap that this article will also purposely leave aside.
2) The Cap
A cap gives the investor some potential upside for taking the risk right now. Specifically, when a priced round happens and the note converts into equity, the investor gets the lower of the cap or pre-money valuation (factoring in the discount). Say you raise $5M by issuing 10M shares at a $20M cap. Then a year later you do a priced round of 10 on 30 i.e., 30 pre and 40 post. Since 30 > 20 the investor will get 20 as their “ceiling” when getting shares i.e, $20M divided by 10M shares = $2 / share, rather than 30/10 = $3/share. The differences can be huge, potentially 33% more shares in this particular example. Which is why uncapped notes are very uncommon. Investors will typically say okay to them if
a) they really want to become investors and fear they won’t have a chance later
b) the priced round is happening very shortly afterwards i.e., the startup can push back on a cap
c) the company doesn’t want the cap to be interpreted as their next round’s valuation
3) The Discount
A discount gives the investor a different kind of upside, namely they get a simple discount in the share price. To illustrate this the most easily let’s assume you raise $5M by issuing 10M shares without a cap. When the priced round happens of 10 on 30 i.e., $40M post, the new share price investor is $30M / 10M shares = $3 / share. The VC gets to pay 80% of that i.e., $2.40 / share when converting into equity. Remember if there had been a cap then the investor gets the lower price per share, either determined by the cap or by the discounted method we just went through. When should you as an entrepreneur do convertibles without a discount? The math should make it obvious the discount is really useful for investors if the company raises below the cap in the future. So if you want to go down this route, convince the investor the cap is a number you can beat.
4) Historical Norms
Caps are not valuation. Period. Some pre-seed and seed are priced but generally the first priced / institutional round is the A and that often serves as a guidepost for caps. Given that A is historically 20-30% dilution, a convertible gets the same expectation i.e., a 2 at 10 cap rather than a 2 at 20 cap. This is obviously market-dependent, as rounds in the last 12 months have had caps much higher than the norm. Also, convertibles typically happen at pre seed or seed but there are reasons to do them at a much later stage of the company. In those cases the “dilution” is typically lower, for example if your next round would be a B, C or D the 10-15% dilution norms around it prevail.
As for discount rates, most companies do 15-20% given the expectation of raising the next round in 1-2 years. But if there is enough uncertainty around it, one way to balance entrepreneur and investor interests is to do a graduated discount, say default of 10%, 15% if you raise between 6 months and 12 months, and 20% thereafter.
Originally published on “Data Driven Investor,” am happy to syndicate on other platforms. I am the Managing Partner and Cofounder of Tau Ventures with 20 years in Silicon Valley across corporates, own startup, and VC funds. These are purposely short articles focused on practical insights (I call it gl;dr — good length; did read). Many of my writings are at https://www.linkedin.com/in/amgarg/detail/recent-activity/posts and I would be stoked if they get people interested enough in a topic to explore in further depth. If this article had useful insights for you comment away and/or give a like on the article and on the Tau Ventures’ LinkedIn page, with due thanks for supporting our work. All opinions expressed here are my own.