What is a Convertible Note Valuation Cap?

Business
Published on May 23, 2023
What is a Convertible Note Valuation Cap?

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Hey, it's Scott Orn at Kruze Consulting and today we're talking about what is a convertible note valuation cap?

And, you know, when people invest money via a convertible note into a startup, it's typically a angel pre-seed, seed rounds. They're really looking for the big upside that comes over time when the company's gonna IPO or get bought for a lot of money, five, 10 years from now. And so no one would give startup founders money if it was just a pure debt return, like a five or 10% return because you wouldn't make enough money as an investor and you'd be out of business really quickly. So they really do it for the equity upside and the way to determine the equity entry point and then thereby the equity upside is by the valuation cap.

So you've got a bunch of other items that you're negotiating the convertible debt, and I've covered that in other videos, but here we're just talking about essentially the equity, the convertible valuation. And so for example, you might invest in a seed-stage company at a $10,000,000 cap. That's the lingo that people use. That means if another round of capital, usually institutional VC, comes in with a Series A and does the round at 20, 30, $40,000,000 valuation, your cost basis for that equity is $10,000,000, and you can kind of see how it works, like you've given the angel investor a really strong incentive to come in early because they know that even though they're gonna lose some of these, they're gonna get in a lot earlier than some of the institutional VCs.

And, therefore, their return profile is actually a lot higher. On the ones they invest in early, they can make a lot, a lot of money. And so the convertible cap is heavily negotiated. It's something you're probably gonna do if you're a founder with like your lead investor. It may be a pre-seed or seed fund or maybe it's just a high net worth person who's kind of taking the lead and putting up the bulk of the capital. You'll negotiate this with them. You know, at pre-seed we usually see kind of five, $6,000,000 caps.

At seed, it's 10, $15,000,000. Maybe 20. That's pretty aggressive. And then if you're doing something kind of before, you know, a Series A is kicking off, just trying to squeeze some money into a company, you might see a 20 or $30,000,000 cap. The cap is negotiable. So you could do a cap at a $50,000,000 valuation or a $100,000,000 valuation. It happens, but that is something that's negotiated between you and the investor. So I hope that helps. You know, angel, seed, you know, startup investing is very difficult, and so getting in at a low entry point for investors is really important and making sure they make enough money on the winners is really important.

And so that negotiation on the value cap, valuation cap, and what that valuation is gonna effectively be in the future is really, really important. So good luck. Hopefully it's a collegial conversation. If it's not collegial, probably not a good partner for your startup long-term, so hopefully you find someone nice, easy to work with, and who believes in your vision. That is really, really important. If you have any questions on this, hit us up at kruzeconsulting.com. Thank you so much. Bye.