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Convertible note caps

Paul Clark
Paul Clark
Last updated: June 4, 2024
Venture south fallback

The “default setting” for entrepreneurs raising capital is to propose a convertible note. If you know about VentureSouth and many other early stage investors, you might know our “default” response then would be “no thanks.”

Following Matt’s definitive case against convertible notes (plus the convertible note primer here and our quick “back to basics” summary of valuations), we wanted to explore one item – convertible note caps and their implications – more fully.

To recap the primer, the valuation cap establishes the maximum conversion price noteholders would pay if the note converts to equity. The note will convert at the lower of the price based on the conversion discount or based on the valuation cap. We provide an illustration here of a note with a 20% discount and a $5M cap.

So far, fairly well-known information. In this post, though, we’ll dig a little deeper into the need for a cap, its implications when switching to a priced round, and two “anchoring” issues that you might want to consider before setting that cap.


First, do you need a cap? Well, legally speaking, no: you could simply have a convertible note that converts at a 20% discount to the eventual equity round’s price, regardless of what that price is. This is an “uncapped note.”

You could do that. However, know that most investors will not accept that for most companies raising capital. Only the most compelling (and likely successful and serial) entrepreneurs can plausibly ask for an uncapped note.

In fact, “uncapped note” has become an inside joke in the VC world – a shorthand for a bad or highly overrated investment opportunity.

So, generally speaking, you’re going to want to have a cap.


Second, how do valuation caps compare to valuations? Having set your cap, your next conversation with an investor that dislikes notes goes something like this:

Entrepreneur: we are offering a convertible note with a 6% interest, 20% discount, and a $4 million valuation cap.

VentureSouth: we only invest in priced rounds.

Entrepreneur: OK, then we are offering preferred equity with a $4 million pre-money valuation.

See what happened there? Changed structure but kept the same “headline valuation.” That sounds reasonable, right?  Wrong.

Our view is that those “valuations” are not comparable. Here’s a few suggestions why:

1.       Time value of money: $4 million pre-money today is a valuation. A $4 million cap on a note is a potential valuation at some point in the future. $4 million today is not equal to $4 million two years from now, thanks to inflation and other uses we have for our capital.

2.       Risk of not converting. $4 million pre-money today is certain. The convertible note conversion might come after a year or two, after four years if you can persuade noteholders to stay unconverted, or possibly never! $4 million is not equal to a possibility of $4 million in the future.

3.       Assistance. The future $4 million cap becomes relevant only once your company is more advanced than it is today (and hopefully far more advanced!). This is a position you will have reached in part thanks to our investment (and, for good investors, our help). A $4 million valuation in the future that we helped you create is not the same as a $4 million valuation today.

A valuation cap is not a valuation.

This is our view, and those of others (for example see here): it’s not a universal view, but most investors don't consider cap = valuation.


Third, anchoring issue #1. OK, so no harm done by the earlier misfire over cap = valuation; let’s start over and find a price.

Unfortunately, things are not quite that simple. Putting a number on the table as a valuation cap was anchoring – setting a price in the mind that unconsciously affects what people are willing to pay. This might work on a new investor who goes along with the $4M cap/not-valuation; or a slightly more sophisticated one who understands cap ≠ valuation and so reduces it a bit.

Investors that do this every day, though, are likely less influenced by the anchoring. In fact, what you’ve actually done, is tell us what price you think we should pay – and it’s a much lower number than you think!

What do you mean? Let’s go back to the example of a $4M cap. You’re anchoring $4M as a reasonable price to pay for equity when a conversion happens – because in general next rounds tend to happen somewhere near the valuation cap. Not always, of course – some companies have an explosive hockey-stick and get way past that cap. But pretty often the valuation cap and the valuation on the next round are pretty close.

What does that imply for the valuation today?

Well, first notice that all the reasons in the previous post suggest a valuation today is lower than a valuation tomorrow. A $4M cap must be higher than the valuation today.

How much higher? Let’s assume a two-year note and that you add value to the company in a fairly “linear” way at our target IRR of 50% per year. This creates a “valuation” of $1,777,778! (Valuation today * 150% * 150% = $4M valuation later). Bet you weren’t deliberately trying to guide towards a sub-$2M (post-money) valuation! 

That’s probably taking it too far. In reality, you would expect value creation to be accelerating the more mature the company gets, so the IRR is driven more by the later years than earlier. But unquestionably we are heading towards a valuation that is substantially lower valuation today compared to a cap in two years of $4M.

And the kicker is it might be a even lower than if you had simply suggested a reasonable valuation for a priced round initially. Say $3.2M in this example.

And the absolute worst case is an investor concluding that you are not doing your homework or trying to be reasonable, and therefore simply deciding to pass.


Lastly, anchoring issue #2.

One other consideration: when you are raising the next round, convertible notes create problems. Matt covered many of those already. Here, though, we note one specific “anchoring” issue: investors in the next round will be paying close attention to the cap on the previous round.

As noted above, the valuation of the next round is often near the valuation cap. The valuation cap can act as an anchor, to pull thinking around this number. Entrepreneurs reluctantly raise below that cap; new investors reluctantly invest much above it because the cap creates substantial dilution for the founders.

So while you’re dodging a valuation on today’s note, you are creating downstream negotiation implications you might not like.


Hope those thoughts provide some caution as you are thinking about the cap on your note. And just maybe, if you’re going to have that negotiation over the cap, consider pricing the dang round already!