A cap is not a valuation
(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.