The Cap Trap

http://www.aaronkharris.com/the-cap-trap

by katm • 13 years ago

43 9 13 years ago

blahedo• 13 years ago

Originally posted and more useful title: "How ego and misunderstanding sabotage convertible notes"

I'd suggest the title: Cap Trap drives to the root problem. The fact that the convertible note cap has become the pseudo-pricing of the round, creates considerable contention between angel investors and founder, which compromises the major benefit of convertible notes to raise money quickly. Obviously ego and/or misunderstanding can acerbate this issue, but ultimately, it's the focus on the cap number that introduces many of the complications of a priced round.

andrewfong• 13 years ago

Just wanted to comment on this tidbit: "However, if by some miracle they raised above the cap, the investors would get the same % they initially agreed to, but would also get higher liquidation preference."

This isn't necessarily true. If I recall correctly, the default language in Clerky's notes or the YC Safe provides mechanisms for getting around this, either by (a) issuing a different class of stock to noteholders with a different liquidation preference (e.g. Series A vs. A-1 shares) or (b) issuing the extra shares resulting from a discount or cap in common rather than preferred.

akharris• 13 years ago

You can definitely write in provisions that would prevent the increased preference, but I don't believe those terms are standard (and I can imagine an investor fighting them quite a bit).

As for the SAFE, you're right that it has protections on the liquidation preference - one more reason that it's superior to a convertible note.

rmorrison3• 13 years ago

The other major issue with convertible notes are that entrepreneurs can end up giving away a lot more of the company than they realize. For example, if the company does a priced round with a pre-money valuation less than the cap (or with uncapped notes, less than expected.)

The median pre-money Series A valuation for all WSGR startups is ~$8.0m [1], which is likely on the higher end.

Also, uncapped notes do not get diluted when raising your Series A, which is additional dilution for the entrepreneur.

For example, let's say you raise $5m uncapped notes with no discount. If you then raise a $3m Series A at a $8m pre-money valuation, you'll end up giving away more than 50% of your company, not counting interest or option pool. At a $15m pre-money valuation, you'll be giving away over 40% of your company.

Entrepreneurs should be equally careful with SAFEs.

[1] http://www.wsgr.com/publications/PDFSearch/EntrepreneursRepo...

shalmanese2• 13 years ago

If you raise $8M in funding and your company is only valued at $11M, then you deserve to own less than 50% of your company since investors could have done almost as well sticking their money into a bank account.

I don't think the numbers given in your example are particularly realistic. Series A rounds are almost never smaller than seed rounds and are usually at least 3x - 10x.

rmorrison3• 13 years ago

My point is that entrepreneurs can get into jams inadvertently.

If you raise $2m or $3m on uncapped, no-discount notes, you basically need to turn that into a $10m+ pre-money company upon raising your Series A. If you raise $4m or 5m+ seed, it gets even harder. And this is assuming no cap or discount, which is unlikely.

You are correct that Series A rounds are usually not smaller, in which case if you raise several million seed on uncapped notes and cannot leverage that into a much more valuable company, you'll be unable to raise a Series A.

This is all manageable by the entrepreneur, but it's important to make sure you understand what's happening and where the risks are. It seems a lot of entrepreneurs don't.

The Cap Trap

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