

The Cap Trap - katm
http://www.aaronkharris.com/the-cap-trap

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rmorrison
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...](http://www.wsgr.com/publications/PDFSearch/EntrepreneursReport-Q3-2013.pdf)

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shalmanese
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.

~~~
rmorrison
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.

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shalmanese
If you raise $3M on a note, you're already implicitly valuing your company at
$10M - $15M since since each round is meant to take roughly 20% of your
company. Investors wouldn't give you $3M unless they thought your company was
worth $10M already and you wouldn't take it unless you thought there was a
decent chance of bring your company to a 30M valuation by the time the money
ran out.

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rmorrison
There is no written rule that says "each round is meant to take roughly 20% of
your company", and a company is never guaranteed another round. I know several
entrepreneurs who have been given term sheets for over 50% of their company.
Or no term sheets at all.

There is no "rule" about implied valuation either. Entrepreneurs can raise $3m
in notes $100k at a time, usually from investors that are much less price-
sensitive than VCs leading a priced round. It's a lot harder to raise a priced
Series A at a $10m+ valuation than raising piecemeal notes at the same
valuation cap (or uncapped notes, even).

Again, this is all manageable by the entrepreneur, but there are no "rules"
like it often appears from the outside.

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andrewfong
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.

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akharris
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.

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

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kevinastone
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.

