September 29, 2011
Over the past few weeks several entrepreneurs have been asking me about my opinion on convertible notes with caps. Jason Mendelson has posted a good summary of capped convertible notes on his blog here, which is mostly positive about the instrument while also acknowledging that entrepreneurs would like to avoid them. David Hornik, on the other hand, explains his blunt opposition to the instrument here. Meanwhile, my friend Michael Yavonditte hates the concept so much, he has vowed never to invest in a startup that has one.
In my role as a seed stage VC, caps make my life complicated. I generally invest in multi-institution syndicates, with each institution attempting to get to a target ownership level while leaving the founders with a strong ownership position. A traditional angel convertible-note-with-discount is relatively easy to work with, because I can control the amount of cash the syndicate invests, and I can pick an appropriate pre-money valuation to get to my (and the entrepreneur’s) desired ownership level.
The worst case scenario for me is a capped convertible note where the cap is extremely low and not disclosed until the last possible moment. In this situation, 2 things happen that neither my syndicate, nor the entrepreneur, will like.
1. I am confronted with the rude awakening that a chunk of the equity I thought my syndicate was getting is actually going to the owners of the convertible note. If I want to get back to my targeted ownership level, I will need to put more cash into the company. That additional cash may price me out of the deal and cause me to walk away after spending a fair amount of time with the startup.
2. If I do decide to proceed with the investment, my target equity amount will come directly at the expense of the entrepreneur, who will now undergo a funding round with more dilution than they originally envisioned. Neither scenario is ideal.
There are 2 ways out of this mess. The first scenario is to follow Michael Yavonditte’s approach and publicly declare that I will never touch a deal that has a cap. Hopefully an announcement like that by enough VCs will scare angels out of demanding them in the first place. Alas, I think that ship has sailed, with plenty of other VCs funding companies with caps all the time.
The other way is to set caps sufficiently high to ensure they don’t stifle a company’s ability to raise a follow-on round of financing. Because a cap guarantees an angel a minimum ownership stake in a company, entrepreneurs should negotiate their caps with an eye towards the effect on the post-funding cap table. Raising a $300K convertible note with a $1M cap means giving the angels at least 30% of the cap table after a future raise. 30% becomes awfully expensive when you have a 20% option pool and 2 institutional investors demanding 20% of the company each, leaving 3 founders to split the remaining 10%!
I personally have a hard time trying to think of a scenario where you would guarantee your angels more than 10% of a post-funding cap table. Last, please tell your VC about the cap as soon as you start talking about valuation. You really don’t want to surprise your VC with a cap table landmine after the core parameters of a deal have been set, because any lost equity position is going to be yours.
Editor’s Note: This is a special contribution from Aziz Gilani, a venture capitalist with DFJ Mercury.
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