A cap is not a valuation

Posted: September 12th, 2012 | Author: | Filed under: Startups | 14 Comments »

(apologies in advance: the content of this blog post is for startup financing geeks)

I was having drinks with a dozen founders who should know better.

“So YC company valuations are up around $10mm.  And some are $20mm+.”

“What!?” I exclaim.  “That’s crazy!  It’s insanely high.  And, wait… I thought YC was using convertible debt for most of their rounds?”

“Yes, they are.  They’re doing convertible debt with a $10mm-$20mm cap.”

AARGH.  Come on.  This is bananas.

Convertible debt is a loan.  It’s a loan that converts in to equity at one of two prices: the price the next investor pays, or the price of the cap, whichever is lower.  It’s basically a postponement of a valuation exercise: it says the value now will be determined later, but will be no higher than the cap.

You may have noticed a giant humungo discussion going on in the twittersphere (Storify link) after Mark Suster’s insightful critique of the financing perils of convertible debt. That’s about the appropriateness of early investors getting discounts (or lower caps), and frankly it’s way out of my league. This is about something much more basic.

A note with a cap does not imply that the company’s value is equal to the cap.  This is easily demonstrated by a simple thought exercise.

It is unusual but not unheard of for companies to get convertible notes without a cap.  If the cap is the valuation, then those companies are infinitely valuable, since the cap is infinite.  Which is, of course, absurd.

So what’s the valuation of a company that takes a note with a cap?  Well, you don’t know.  It’s a range – from zero, to the cap.

Say it with me: Caps aren’t valuations.

Carry on!

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  • ruchitgarg

    If cap is too high, early investors believe that this company would be much more worth at the time of conversion..and thats how these founders are thinking about valuation..

    So technically it might be debt, ability to create the perception that it would be worth $30mil in a year (and hence cap is $20mm) is i think a YC effect..

  • joewallin
  • Amen! Shout it from the rooftops. It wasn’t all that long ago that convertible notes didn’t have valuation caps. As you said, the issuing companies — unfortunately for their investors and founders alike — weren’t infinitely valuable!

    I wasn’t aware of Mark Ury’s Storify piece; I put one together myself with additional links and references. Call the “unabridged” version versus Mark’s more concise summary of the conversation. Anyway, for those who can’t get enough of this startup finance geek material, it’s located at http://storify.com/antonejohnson/convertible-debt-priced-equity-rounds-and-timing .

  • It is (at least from the investors side) when the cap is too low, though. Think about that ;)

  • joewallin

    John, that is certainly one of the problems. Did you see those articles at quora I linked to above?

  • I’m going to try to find some time to write up more detailed thoughts on this later… have another blog entry worth at least. :)

  • Nope. If the cap is $5mm, the expected valuation of the investment is <$5mm, since there's a nonzero chance that it might convert lower. So a cap is… say it with me again… the cap on the upper bound of the valuation, but the expected valuation is always lower. If the cap is high relative to the expected amount of the next financing it's a lot lower, if it's low it's a little lower.

  • joewallin

    That would be great Dan. I think that what you described going on with founders, with them talking like the cap equals the valuation, is also happening with investors! They are doing the same thing, but of course from the harsher valuation perspective. I think David Rose is doing that in his Quora answers.My thought is–why would you waste your time (and lawyer fees) doing a convertible note if you knew the valuation? Just do a fixed price round and get it over with (1 legal steps versus 2 and save legal fees and Form D filing fees, etc.). One of the motivations for doing a convertible note has always been to punt the valuation question until later–when typically some bigger investor who had more sophistication came in and set the valuation. I understand the motivation for a cap–to cover off the strange, outlier situation when a note investor thinks they are going to get roughly say 2-5% of the company, and the company then raises money at some ridiculously high value and the note investors gets a fraction of that. But that’s the point–the cap is supposed to cover off the bizarre, unexpected outcome–not equal the current value. I look forward to your thoughts!

  • Joe, I agree with you.

    Another irony lurking in the wings: if and to extent the ecosystem can standardize around Series Seed, there may be far more variation in note terms, making those the financing docs that will entail more lawyer time.

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  • Only three years too late:

    Those blog posts assert that caps should be set to equal valuations because “[angels take] the economic risk of investing early”. Then it claims that counter-examples indicate “a special case” but I didn’t see any explanation of why.

    I don’t think there’s anything to be learned from those posts, please point out if I’m missing something.

  • Gnosis Media Group

    Dan, when you say, “the price the investor pays”, does this refer to the amount they invest?

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