If an investor would rather own 5% of a $20m company than 3.3% of a $30m company, and specifically limits a company's growth to achieve that end, then it's likely someone no founder would want to work with. Make the pie bigger, no?
The real problem with capped notes is that they serve as a proxy for price. If you're going to price it, just price it. But if a note had a floor + cap that served as a min/max range for what everyone felt comfortable with, and then utilize a discount to do the actual work of allowing for uncertainty in the valuation, that would be the setup that best encapsulates the spirit of convertible notes (of course, the devil is always in the details).
> If an investor would rather own 5% of a $20m company than 3.3% of a $30m company
It's not that simple because you're not factoring for time. Yes, both of those stakes are worth $1m, but the risk levels taken by an investor are different. For example, would you rather own 5% of Amazon when it was worth $20m, or 0.01% when it's worth $10b? Those are both $1m stakes if you ignore time, but the latter would've been worth much less than the former.
- If your next round is $5m at $20m pre, I'll own 8% (post-dilution) which will be worth $2m.
- If your next round is $10m at $40m pre, I'll own 8% which will be worth $4m.
If your valuation doubles, so does the value of my investment, and I keep an 8% take in either case.
Uncapped note
I invest $1m on an uncapped note, 20% discount.
- If your next round is $5m at a $20m pre, I own $1.25m (5%).
- If your next round is $10m at a $40m pre, I own $1.25m (2.5%).
Note that 1) my upside is capped to $1.25m (that's the 20% discount I got) and 2) the better your next round, the lower my ownership.
Closing thoughts
The reason the uncapped note is even more unattractive is that most companies have some perceived ideal outcome. Let's say it's a max $2b exit for this specific company. For a priced round, I own 8% of a company that could go up to $2b in value. For an uncapped note, I own 5% if you raise at a $20m pre, or 2.5% if you raise at a $40m pre. Note that the better you do, the lower my percentage, and hence the lower my potential upside. If you raise at a $20m pre my stake might be worth $2b x 5% = $100m someday. If you raise at $40m pre my stake might be worth $2b x 2.5% = $50m someday. If you really knock it out of the ball park and raise $20m on an $80m pre for your Series A, my max upside is $25m. Again, this makes no sense because I invested $1m at the exact same time in both the priced round and the uncapped note round, but in the priced round instance I own 8%, while in the uncapped round I probably own much less, and the better you do on your way to a $2b exit, the worse I do. That's a strong misalignment and there's no way for me to make that pie bigger.
I said this in another comment but it seems like these cases are assuming a long time passing between the SAFE and the priced round. Not sure if DelaneyM and pmcaffey are referring to that.
If SAFE is a way to start what would be a priced round (a few months), then your numbers would tell a different story. You getting to invest $1M and $10M cap, and then the company raising at $20M valuation later, means that you got an unfairly low priced deal (assuming company's valuation wouldn't naturally double in those couple of months).
In short timeframes (SAFE -> Priced rounds), its hard to imagine something other than discounts being fairer to all parties concerned.
In longer timeframes where the next priced round is a Series A, an year later, your point stands and is well taken.
Thanks Leo for the detail response. The problem with this analysis is that you're comparing a priced round to an uncapped note, but using totally different and arbitrary parameters (ie. 20% discount).
I agree 20% discount is not an accurate assessment of the risk and potential increase in value from seed to A, which is usually 3x. Also, the original purpose of a note is to solve the problem of inaccurately pricing an early stage company. If that's not a problem then there's no point in not pricing. But if there's great variation in the potential of a company, then it makes sense to use a variable pricing model, which a significant discount (30-60%) better accounts for. Add in a cap and a floor (something like $4m - $40m) to protect founder & investor in extreme situations like you described.
Obviously a fixed price is better for you, the investor. But is it better for the company? Is it the best way to model the uncertainty of valuation? You argue for not dissentivizing the investor. What about the founder who raises $1m seed at $5m valuation, then raises Series A at $30m? They mispriced their seed round, and the likelihood of the A investors finding a way to diminish the value of the seed investors greatly increases.
Just an alternative view of things from an outside.
I appreciate the follow up. I think where we disagree is that a priced round is a disincentive to the founder. Instead of a disincentive, I think a priced round is "fair." A few quick comments:
- are there any other areas where, as a buyer/investor, you buy at a discount to a future price instead of an estimated current price? For example in places where houses appreciate quickly, people still buy houses at a fixed price. No seller ever says "this house might be worth $2m-5m in 10 years, so instead of buying it for $1m today, which don't you buy it for a 20% discount to when you sell it 10 years from now?" Same thing with paintings, stocks, etc.
- the $5m -> $30m mark-up is not a mispricing. For public stocks, pricing is based is based on expected cash flows. For example, if a company is expected to make $10m/year for 30 years, it might be worth $300m today, minus an adjustment for inflation (so maybe it's only worth $200m today). For startups, the valuation is based on "% chance of a huge outcome." So when a company goes from $5m to $30m in valuation, that doesn't mean its revenues jumped 6x. What it really means is investors think the company made enough progress so that instead of a 1% chance at a $1b exit, there's now a 6% chance at a $1b exit. In that regard, the company is worth $30m today, but it was also not worth that at the seed round.
There is no way to know at the beginning if you'll be a $0M or $30M company and to make their portfolio math work they need as much upside as possible if you get to a higher valuation. The pie is fixed at 100% and everyone is fighting for more of it.
The real problem with capped notes isn't the proxy for price, it's that the cap table is impossible to discern. Capped notes actually do have an advantage in that you can do a rolling close of your round, so you don't have to have everyone invest at the same time on the same day. The downside is that it is hard to explain to your employees exactly how much they own since it depends on how the notes convert.
can't price it without it being a real equity round in which case closing costs are the real issue (the other reason why converts work well at early stages)
The real problem with capped notes is that they serve as a proxy for price. If you're going to price it, just price it. But if a note had a floor + cap that served as a min/max range for what everyone felt comfortable with, and then utilize a discount to do the actual work of allowing for uncertainty in the valuation, that would be the setup that best encapsulates the spirit of convertible notes (of course, the devil is always in the details).