Avoiding the Early Valuation — Are You Really Going To Do This With Convertible Debt?

As I am sure entrepreneurs appreciate, fundraising is extremely difficult. Throw on top of the difficulty of just raising capital, the valuation of an unproven idea and discussions with potential investors regarding valuations can be painful. Founders are wed to a high valuation based on potential while investors are not willing to invest on such valuations with no proof of concept or market acceptance. So how do the parties bridge the gap?

The fix to the valuation gap has been the convertible note instrument. The purpose of the convertible note is to defer the valuation of a start-up until the idea has been more developed. Not only does the convertible note solve the valuation issue, a convertible note financing is generally simpler, cheaper and can be documented more quickly than a traditional Series A or other equity financing round. Many of the negotiating points of an equity financing round can be deferred in a convertible note financing.

When negotiating terms of a convertible note, there are generally only a few significant business terms to negotiate. These terms include interest rate, maturity date, conversion thresholds, conversion discounts, and warrant coverage, if any. The beauty of the convertible note is that the discussion on valuation is delayed until a future date. The funds from a convertible note can help the start-up develop the idea and establish the key metrics to determine a fair and reasonable valuation at the next financing event.

This creates a win-win situation for the founder and the investor. It is a simple financing, the founder gets the necessary capital and the investor can put his money to work.

Not so fast.

Investors now want protection from an early home run by the start-up. If the start-up is wildly successful with the limited capital raised from a convertible note bridge round, the convertible note could convert into equity at a much higher valuation than is desirable or anticipated by the investors. To avoid losing out in the home run scenario, investors now request "Price Caps" as a part of the terms of the convertible note. A price cap essentially sets a maximum valuation of the start-up to protect the investor from converting into equity at an undesirable high valuation.

This defeats the purpose of the convertible note and complicates what used to be a simple negotiation. Why? Because now we are back to talking about valuations which is the ultimate discussion the founders and investors were trying to avoid in the first place. Founders and investors now must establish the price cap on conversion. The price cap is generally considered investor friendly while others will argue that the convertible note without a price cap is company friendly. Regardless if price caps are investor or company friendly, if you are going to negotiate a price cap, then it may be beneficial after all to explore equity financing and see if there is a valuation that works for both parties -