Convertible Note Cap

A convertible note cap is a limit for the maximum valuation at which the funding made to the company through the convertible note can convert into equity.

The debt of the investor would convert at a lower value of the next qualified priced round and the cap. In short, the “cap” in the convertible note is the maximum price at which the debt of the investors would convert into the equity in the next round of equity financing.

How Convertible Note Cap Works?

When a startup issues a convertible note, it borrows money from investors with the promise that the loan will convert into equity at a future date, typically during the next significant equity financing round. The conversion terms often include a discount to new investors on the price per share, but a valuation cap can also be included to benefit early investors further.

Valuation caps in convertible notes play a crucial role in shaping a startup’s financial and ownership structure during subsequent funding rounds. By ensuring a favorable conversion price, they provide protection and potential upside for early investors.

Example of a convertible note cap

Here we illustrate an example of the impact of a convertible note cap on an investor’s conversion and resulting equity stake in a startup. For instance, in case an investor purchases $20,000 of a company’s convertible debt, and the company becomes very successful with the next equity round at a valuation of $200,000, the investor would only be able to convert their debt into 10% of the company’s shares. However, if the convertible note had a convertible cap of $100,000 on it, even if the company’s value significantly increases to $200,000 at the next round, the investor would be guaranteed to convert their note at the lower value of $100,000, thus increasing their shareholdings after conversion to 20%.

Hence, when a “cap” is placed on the convertible note, the investor is insured that they would not own less than 20% of the company when the next equity round is there. In case there is no cap, and the next round has a high valuation, the investor could be indefinitely diluted.

Benefits and Implications of Convertible Note Cap

Here, we added the potential benefits and implications of convertible note cap for investors and founders:

For Investors

• Risk Compensation – The cap compensates early investors for the higher risk they take by investing at an early stage. It ensures they get a better deal if the company’s valuation increases significantly before the next financing round.
• Ownership Stake – A lower cap can result in a larger ownership stake for the note holder as they convert their investment into more shares at a lower price per share.

For Founders

• Dilution – While caps are attractive to investors, they can lead to significant dilution for founders, especially if the company’s valuation increases substantially before the note converts.
• Negotiation Complexity – Including a cap adds complexity to negotiations and can sometimes lead to unintended consequences, such as misaligned incentives between founders and investors.

Understanding these factors makes convertible note caps a valuable tool for investors and founders seeking to maximize their returns while managing risk in early-stage investments.

Secure Your Stake: Convert Risk into Reward with a Convertible Note Cap!

Convertible note caps are a critical tool in early-stage financing, balancing the interests of both investors and founders. They provide early investors with a safety net against high valuations in future rounds while introducing potential dilution risks for founders. Understanding and negotiating these terms carefully is essential for both parties involved in the financing process.

If you want to know more about convertible note cap, Eqvista can assist you with it. Furthermore, if you have just started your company and are looking for the right cap table application to track all your shares, check out our software.