The Problem in Everyone’s Capped Convertible Notes

TL;DR Nutshell: Standard capped convertible notes have a flawed structure in that noteholders often end up, when their notes convert, with substantially more liquidation preference than they actually paid for; which means money taken from founders’ pockets and placed in those of investors, without justification. As companies continue to push their “Series A” rounds further out with various series of capped convertible notes, the problem is growing, and a corrected note conversion structure should become the norm.

The existence of the “liquidation overhang” problem in capped convertible notes is not news. It can be explained with a simple mathematical example:

Assumptions for Hypothetical:

  • $500K seed round with notes carrying a $2.5MM valuation cap.
  • Series A has a $10MM pre-money valuation, resulting  in a per share price for new money of $4.00.
  • The Series A has a run-of-the-mill 1x participating liquidation preference. This means that the Series A have a per share liquidation preference of $4.00.
  • The $2.5MM valuation cap means the notes convert at $1.00.

Under the above example, the $500K in notes will convert, ignoring interest, into 500,000 shares.   $500,000 / $1.00

If the Notes convert directly into the same Series A preferred stock as “new money” investors get (which is what most notes require), their aggregate liquidation preference is $2 million.  500,000 shares * $4.00

So those investors paid $500,000, but they have $2 million in liquidation preference. In other words, they got a 4x participating liquidation preference. The $1.5 million difference is the “liquidation overhang.”  Ask me if I think founders/common stockholders care whether they will get an extra $1.5 million in an exit.

If you increase the size of the seed round (which is happening in the market), the overhang gets bigger on a dollar basis. (1MM shares * $4.00) – $1,000,000 = $3 million.

If you increase the gap between the Series A valuation and the seed “cap” valuation (which is also happening in the market), the overhang also gets bigger.  A $15 million Series A valuation, with a $6 share price, produces a liquidation overhang of $2.5 million.  (500,000 shares * $6.00) – $500,000

So as seed rounds get larger, and Series A rounds are extended further out (with higher valuations), the liquidation overhang grows, and more money is transferred from founders to investors.  Historically, convertible notes were called “bridge” notes because they were closed only a few months before a full equity round, offering a small discount to the Series A price. When the price differential is only 10-20%, the overhang is perhaps worth ignoring.  But when the Series A valuation is 2-3x+ of the seed valuation, it’s time to pay attention.

The Most Viable Solutions

The two most common solutions to the liquidation overhang are as follows, and both have tradeoffs.

Create the “Discount” with Common Stock – Instead of issuing (in the above example) 500,000 shares of Series A to the noteholders, issue them 125,000 Series A shares, and the remaining 375,000 as common shares.  In the end, they still have 500,000 shares, but their liquidation preference is equal to their purchase price. 125,000 * 4 = $500,000.

The downside to this approach is that it can significantly affect the voting of common stock.  There is almost always a stock class divide with “common stock” representing founders, executives, employees, and other people performing services, and “preferred stock” being investors. This keeps things simple when calculating approval thresholds for a major transaction – the “common vote” is a very distinct group from the “investor vote.”  However, depending on the numbers, it’s very easy with this “common stock solution” to reach a point where a very large chunk of the common stock is in fact investors, reducing the voting power of founders.  Not an insurmountable problem, but it is a problem.

Issue Sub-Series of Preferred Stock – This is actually my favored approach. In the above example, instead of issuing 500,000 shares of Series A to the noteholders, issue them 500,000 shares of Series A-2. Series A-2 would just be a series of stock that is exactly the same as the Series A in all respects, including voting, except for the liquidation preference (and basis of anti-dilution and dividend rights, which are related). The Series A would have a per share liquidation preference of $4.00 per share, and the Series A-2 would have $1.00 per share. Problem solved.

The most commonly brought-up downside to this approach is that it creates more complexity in the Company’s deal documents and cap table.  While it’s true that you will need to do a bit more work in the company’s deal docs, it does not take that much work to create a Series A and Series A-2, but have them all work together for everything other than liquidation preference.  Even if you have multiple valuation caps, doing a Series A, A-2, A-3, etc. is not that hard.

My somewhat cynical view is that this complaint comes mostly from (i) investors who are trying to convince founders that all of this liquidation overhang “stuff” isn’t that big of a deal and not worth addressing (meaning, an extra few million in their pockets isn’t a “big deal”), or (ii) lawyers at overpriced firms who are ALWAYS running over fixed legal budgets, so having to do ANY kind of extra customization to their template docs results in kicking and screaming.

In the exact same way that “why do we need two sets of lawyers? just use ours, and save on legal fees” is complete non-sense designed to screw founders, the “just give everyone Series A shares and keep it simple” position is ridiculous given the economic impact on founders.  If you’re being told to pay a few extra thousand in legal to potentially save several million in an exit, the issue is fundamentally an IQ test.

Should Non-SV Founders Use SAFEs in Seed Rounds?

Nutshell: Because of the golden rule (whoever has the gold…), probably not – at least not for now.

Background Reading:

For some time now, there have been people in the general startup ecosystem who have dreamt that, some day, investment (or at least early-stage investment) in startups will become so standardized and high velocity that there will be no negotiation on anything but the core economic terms. Fill in a few numbers, click a few buttons, and boom – you’ve closed the round.  No questions about the rest of the language in the document. For the .1% of startups with so much pull that they really can dictate terms to investors (YC startups included), this is in fact the case.  But then there’s the other 99.9%, much of which lies outside of Silicon Valley.

Much has been written about how SAFEs were an ‘upgrade’ on the convertible note structure, and in many ways they are.  But anyone who works in technology knows that there’s a lot more to achieving mass adoption than being technically superior, including the “stickiness” of the current market leader (switching costs) and whether the marginal improvements on features make those costs a non-issue. And any good lawyer knows that when a client asks you whether she should use X or Y, she’s not paying you for theory. You dropped that sh** on your way out of law school.

This isn’t California

From the perspective of founders and startups outside of California, which are the focus of SHL, the reality is that going with a SAFE investment structure is very rarely worth the cost of educating/convincing Texas angel investors on why they shouldn’t worry and just sign the dotted line. The entire point of the convertible note structure, which by far dominates Texas seed rounds, is to keep friction/negotiation to a minimum.  Yes, there are many reasons why equity is technically superior, but that’s not the point.  You agree on the core terms (preferably via a term sheet), draft a note, they quickly review it to make sure it looks kosher, and you close.  You worry about the rest later, when you’ve built more momentum.  Professional angels know what convertible notes are, and how they should look. They also know how to tweak them.  In Texas, many of them still do not know what a SAFE is. 

And, in truth, many Texas angels and seed VCs who do in fact know what a SAFE is simply aren’t willing to sign one. The core benefit of SAFEs to startups is that they don’t mature, and hence founders without cash can’t be forced to pay them back or liquidate.  To many California investors, this isn’t a big deal, because they’ve always viewed maturity as a gun with no bullets.  But Texas investors don’t see it that way.  Many find comfort in knowing that, before their equity position is solidified, they have a sharp object to point at founders in case things go haywire. I’ve seen a few founders who rounded up one or two seasoned angels willing to sign SAFEs, only to have to re-do their seed docs when #3 or #4 showed up and required a convertible note to close. It’s not worth the hassle, unless you have your entire seed round fully subscribed and OK with SAFEs

Just Tweak Your Notes

The smarter route to dealing with the TX/CO/GA and similar market funding environment is to simply build mechanics into your notes that give a lot of the same benefits as SAFEs. A summary:

  • Use a very low interest rate, like 1-2%. – Many local angels tend to favor higher interest rates (seeing 4-8%) than west and east coast seed investors. But if you can get a very low rate, it’s more like a SAFE.
  • Use a very long maturity period, like 36 months. – 18-24 months seems to have become more acceptable in TX, which is usually more than enough time to close an equity round, or at least get enough traction that your debt-holders will keep the weapons in their pockets.  But if you can get 36 months, go for it.
  • Have the Notes automatically convert at maturity –  This gets you as close to a SAFE as possible, and we’ve seen many angels accept it. If you run out of time and hit maturity, either the angels extend, or the Notes convert, often into common stock at either a pre-determined valuation (like the valuation cap, or a discount on the cap), or at a valuation determined at the conversion time.

How successful you’ll be at getting the above is just a matter of bargaining power and the composition of your investor base. Austin investors, who think more (but not completely) like California investors, tend to be more OK with these kinds of terms.  In Houston, Dallas, or San Antonio, you’ll likely get a bit more pushback.  But that pushback will almost certainly be less than what you’d get from handing someone a SAFE.

Closing Summary: There isn’t, and likely will never be, a national standard for seed investment documentation.  Every ecosystem has its nuances, and working with people who know those nuances will save you a lot of headaches. In Texas, the convertible note, however suboptimal, reigns supreme. Respect that reality, and work within it to get what you want.

What a Valuation Cap Isn’t

Background Reading

In a nutshell, a “valuation cap” is a limit on the valuation that a convertible note will convert at upon a “qualified financing.” Seems simple enough, but there are a few serious misconceptions about valuation caps that I feel someone should clear the air on.  Here’s what a valuation cap isn’t. 

1.  A Valuation Cap is Not a Valuation

Sort of.  In the strictest technical sense, a valuation cap is not a valuation.  It relates to future valuations.  It also doesn’t (generally) require a re-valuation of the FMV of your company’s equity for stock grant purposes.  And if a Series A ends up happening at a valuation below the cap, it’s not exactly considered a “down round.”

But in practice, investors and founders often treat caps like valuations.  When you come across an AngelList profile saying a startup is raising $500K at a $4M ‘valuation’, the majority of the time they mean they are issuing convertible notes with a $4M cap.  This “sort of but not really a valuation” aspect of capped notes is seen by some as the best of both worlds: you get to price a round without all the costs of negotiating  a full set of equity docs.  Others see it as having removed the main benefit of issuing notes (instead of equity) in the first place: deferring a valuation discussion to a future date.  Both sides have good points.

2. A Valuation Cap does not guarantee investors a minimum % of the Company

This is the issue that really needs the most clearing up.  I’ve seen angels make the claim that a valuation cap guarantees an angel a specific % of the Company post-Series A. This is just not true.  In a theoretical sense, a valuation cap guarantees a minimum pre-Series A % of the Company, but the note-holder never actually owns that % because the Series A money comes in alongside the conversion.

Take the example in Joe’s post:

  • $5M cap, $200K in notes (assume no interest for simplicity), $2M in new money at Series A at a $10M pre-money valuation.

I’ve seen investors do the following math:

  • % Ownership Post-A = Investment / (Cap + Investment)
  • So: $200K / ($5M + $200K) = ~3.8%
  • Therefore, they say, the note-holder should own 3.8% of the Company after the Series A.

The problem, of course, is that the new $2M from the Series A is nowhere in this equation.  That 3.8% is a percentage of the Company without the new Series A money coming in.

When you do the math correctly for the full Series A (see Joe’s post), the noteholder’s % comes out to 3.22% of the Post-A company. That’s the number the investor(s) will see on the cap table after conversion. And it could be higher or lower depending on the economics of the Series A.

This kind of confusion shouldn’t happen if you’re working with seasoned angels who’ve done several investments that have gone on to raise a Series A.  But if you’re not (often the case in Texas), make sure they understand the math of their own investment so there aren’t squeals when conversion time comes around.

Founder Convertible Notes – Put Your Money on the Cap Table

It’s quite the norm for a startup to run on its own founders’ sweat equity and personal funds (bootstrapping) until the Company is able to raise outside capital.  A very important question that isn’t asked often enough is, “how do I paper the money I’m putting in?” Does it just go in and disappear? Does it pay for my stock?  While there are + and -s to different approaches, the answer that I almost always arrive at is: treat yourself like an investor.  In other words, paper your bootstrapping in a way so that it goes (eventually) on the cap table.  You benefit economically, and investors actually like to see evidence that you put more skin in the game than just your time.

  • Don’t use it to buy Common Stock – Your Common Stock should almost always be issued at par value ($0.0001 per share or some similar number in your Certificate of Incorporation) at the very beginning of the Company. This is proper because the Company is worth very little from a “fair market value” perspective, and issuing it at a higher price sets a FMV precedent that ends up hurting later employees because they then have to pay that higher price too.
  • Don’t buy Preferred Stock – Unless you’re a seasoned entrepreneur, the documentation and terms are too complicated for you to handle at the very early stages, and you’re not experienced enough to set a valuation. You’ll likely end up setting a bad precedent that will come back to bite you if you bring on real investors.
  • Don’t treat it as a loan – How do you think it looks to an investor if you’re asking them to actually invest (not loan) their money and risk losing it all, but you’re only willing to loan your personal funds? Bad.
  • Answer: Founder Convertible Notes – Issue yourselves convertible notes. Pre-financing, they are effectively a debt claim on your own company.  But upon raising the threshold amount that you set in the notes, they’ll convert into Series A Preferred Stock. This means (1) you now have a liquidation preference that will ensure you at least get that money back on an exit alongside future investors (unlike your Common Stock, which will likely sit beneath them), and (2) you get to vote those shares alongside future Series A investors.  Papering this is also a lot easier than buying preferred stock, and you don’t have to set a valuation.

Background Reading

Issues to Consider

  • Interest rate on the notes: 4-8% is fair
  • Discount on conversion: 20% is fair
  • Qualified financing threshold – $500K-$1M is fair
  • Cap on Conversion Valuation – Probably not a good idea for a founder note.
  • Maturity – Give yourself enough time to raise funding. 18-24 months is fair.
  • What happens at maturity? – Realize that at maturity, the notes will become “due.” This means the person holding the note can, if they want to, demand repayment (they could just extend otherwise) and cause all kinds of problems if they don’t get repaid.  If it’s just one founder or a couple of people you trust, this likely won’t be a problem. Make sure the maturity period is long enough, and be aware of the risk.  A lawyer could draft in extra protections to kick in at maturity, but that customization will cost money.

Good Forms to Use

  • Techstars has a great free set of Convertible Note docs to use here under “Debt Financing Structure. For founder notes, you don’t need the term sheet. While these aren’t rocket science, it’s still best to hire a lawyer if you want to completely avoid mistakes. But if it’s just one founder, or a small group of founders with no legal budget, they could probably handle this on a DIY basis if they read carefully.
  • Note that the Company’s Board of Directors should formally consent to the note financing. If you have a lawyer, ask for a simple board consent.  The reality is, however, because only the founders are involved, you can just ratify later when you’ve hired decent counsel.