Valuation · Fundraising

What are the benefits of an uncapped note?

Sati Hillyer Looking to Hire a Ruby Engineer to join OneMob - 2015 Gartner Cool Vendor for CRM Sales

September 1st, 2014

Is there a benefit to going uncapped if you've already been given a high valuation pre-seed? I'd suspect angels would want a lower valuation given the early risk they take on.

However, how do you determine a fair valuation if it's already so high. So wouldn't going uncapped with a 15-20% discount be better?


September 1st, 2014

I disagree with Jessica, I have seen plenty of deals with uncapped notes that use a straight discount between 20-30% for exactly the reason that determining an early stage valuation may be impossible. It depends on how well the investors know the team and the stage of the company, but using caps on convertible notes are a very recent phenomena. In fact, many investors would prefer a straight discount when the alternative is a capped note with no discount (surprisingly common these days, especially with YCombinator companies). 

That being said, as Jessica says, investors will prefer a discount AND a cap since it means they win both ways. 

In the end, while an uncapped note with a straight discount makes your life easier since you don't need to set a valuation, your ability to determine the terms of your note is directly related to your negotiating power. If your company is going great and you don't need the financing, you might be able to set the terms. If not, then you likely need to settle for the terms the investors find the most comfortable.

Roger Rappoport Partner, Procopio

September 19th, 2014

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Whether or not a cap is beneficial, really depends on the facts and circumstances surrounding your raise. I really couldn’t offer any definitive answer to your question, since there are too many unknown variables, and I would need to know: (i) what is your overall funding strategy? (how many raises do you contemplate after this one and the anticipated amounts of each, to get you from one value inflection point to the next (your funding strategy), (ii) who are your currently targeted investors? (iii) what is the total amount of the current round? (vi) have you raised anything/have firm commitments in the current round or will these investors be the first money in? (vi) what is the cap they are suggesting? and (vii) how much are these angels going to invest?

First off, I think that you need to consider the group of targeted investors, and issue a security (and a convertible note is a security) that is appropriate, given your overall funding strategy and the stage of the company, with terms appropriate for the targeted investors.

With respect to angels, I make a distinction between groups of angels and individuals that invest on their own from time to time (as this will determine terms that I include in a term sheet (capped or not capped, for example). I categorize organized groups, such as Band of Angels, Sand Hill Angels, SV Angels etc. as "Angels" and others, that dabble/just invest every once in a while in something interesting, as "high net worths."  The reason that I do so, is to ensure that we present terms that are appropriate to the targeted investors. As a general rule, it is rare that Angels will do a convertible debt deal without a cap (unless you are a rock star/serial, have great traction and have many wanting to throw money at you)!! I represent an angel group in their investments, and can only count very few uncapped deals we have done.  However, I would say that 80%-90% of the time I generally don’t have a cap when I am company counsel and our targeted investors are high net worths or, if we do have a cap, it is generally a pretty high number, or its given only to the very first investors in the round. Just to clarify, if you do have a cap, investors don’t get the cap AND the discount-it’s one or the other. The notes should convert, based on a conversion price equal to the lesser of “price per share which is a 20% discount to the price per share paid by the other participants for shares in the next round (like Series A Preferred) in the next round, or (ii) a price per share determined by dividing $[the cap amount] by the number of shares of common stock of the company on a fully diluted basis.” (The price per share is determined by dividing the cap by the number of shares on a FD basis--so if you have a cap of $5MM, and there are 10MM shares outstanding on a fully diluted basis, the note would convert based on a price per share of $0.50.)

In my view, an uncapped offering is definitely advantageous to the entrepreneur. As a former entrepreneur of 10 years (before becoming a corporate lawyer), who made virtually every mistake in the book, the result of which was a less than stellar exit, I can only tell you that once you embark on your fundraising journey, equity goes so incredibly quickly, and the last thing you want to see is a lousy exit (one where the exit proceeds you receive are not commensurate with or relative to the time, pain, suffering, number of Raman noodle nights and sweat endured to achieve the exit--trust me on this!!). Every point that you give up could be the difference between a good and great or a lousy and good exit, and I am of the view that you need to have a really sound funding strategy in order to maximize the potential for a good/great exit. This is one of the reasons that I always start off with an uncapped term sheet when the targeted investors are high net worths, as the first money in is usually the most expensive.

At the end of the day, every term sheet is negotiable, and my view is, when drafting a term sheet, “why negotiate against myself?” If the investors are in love with you, they won’t walk away because you gave them a term sheet without a cap. This is just the beginning of the negotiation, and there are multiple ways to negotiate around a cap, such as segregating the early and later money or a sliding scale on the discount depending on the premoney in the next round. My general philosophy is “if you don’t ask, the answer is “no.”

If a client were doing a convertible debt round, and an investor asked for a cap to our uncapped term sheet, my analysis would be as follows:

·         How low/high is the cap, and given the amount of the cap, what percentage of the company would we be giving up for the amount of the investment. If the cap is, for example, $3MM, and we are only raising $100K, we will give up about 3.23% for that money in the Series A. That’s not an insignificant chunk of the company, but the first money in is usually incredibly useful, and if you can use those funds wisely to build the value of the company and take it to an important value inflection point, that will significantly increase the premoney in the Series A, it may well be worth taking the money. On the other hand, if the client was going to do a raise of, say, $1.0MM, and the next raise was expected to be at least $5MM, the company would give up 25% of the company to the note holders, and at least 20%-30% to the Series A investors (general rule of thumb is 20-30% for a $3MM-$5MM Series A). The net result is that the founders would lose control of the company at a very early stage which is, in my view, far too soon in the process. If you don’t have a majority of the shares, you don’t control the board and your destiny, in many respects, and founders losing control too soon often results in a founder without a job and/or without a company.

·         If the cap offered is higher than we could reasonably expect the premoney to be in the next round, it probably isn’t a fight we want to have (i.e. begrudgingly capitulate to the investors’ request) or money we would walk away from.

·         “Is this the tail wagging the dog?”  How much is the company raising, and how much is the investor, who is asking for a cap, investing?  I have a convertible debt offering currently in progress. We are doing a $1MM raise, uncapped, to high net worths. We have $600K committed, and the client called to tell me that there were 2 investors who would only invest if we included a cap (at $3MM). My first question was “are they going to complete the round?’  The answer was “no” and they were only going to invest $10K each. The client was actually calling because he was contemplating going for it (before I ran the numbers for him), and this is the situation that I refer to as the “tail wagging the dog.” For a relatively insignificant amount of money, the client was thinking about changing the terms and the entire complexion of the raise, for $20K, which I feel almost certain he would have regretted down the road. Sometimes it’s okay to say no to money, if it has the effect of, or the potential to, completely screw up your funding strategy. If we hadn’t raised anything under the note, and the same investors were instead investing $500K, the discussion/analysis may have been different, and we would have talked through different choices and scenarios.

·         Is this the first money in or have you already raised money under the current offering?  The first money in is the hardest, and sometimes you have to do what you have to do to get it. However, there are a number of different ways to go here. Something that I often suggest as a compromise to the first money, is to provide a greater discount for say, the first $100K or $200K, and the rationale for later investors, who have a lower discount, is that the other investors came in early and came in large, and so they get something that others don’t get. Sometimes I do that with the cap if offering a greater discount for the first money doesn’t work (i.e. have a lower cap for the first money, and then no cap or a much higher cap for the later investors).  So, if you are doing a $1MM raise, and have to give an extra sweetener for the first $100K, it may not be fatal and in this way, you can get the hardest money in, without destroying your entire offering and potentially screwing up your exit.

My advice to you (and to all other startup entrepreneurs) is this: Don’t be a slave to convention. You shouldn’t worry too much about what everyone else is and isn’t doing (okay, you don't want to be totally out in la la land--so you have to be within the realms of reasonableness). My advice is to develop strategies that are appropriate for your company and its stage, and negotiate (not just regarding funding) based on a sound, coherent basis for your position, given the particular facts and circumstances.  I hope that this helps and. if you are interested, I am giving a workshop at our office in Menlo Park (through my meetup) on “Understanding the “terms” in Term Sheets,” and am going through a convertible debt, Series A “lite” and VC Series A term sheet. I believe there are a few spots left and you are welcome to attend. If the link above doesnt work, use this one


Jessica Alter Entrepreneur & Advisor

September 1st, 2014

Almost no sophisticated angel will do an uncapped note. The cap is essentially a valuation and it limits the risk in investing early but still gives the flexibility of a note.  If you already have a term sheet with a valuation and that's the bulk of the financing all other folks will follow that unless something has materially changed since you raised that.

Also, discounts and caps are almost always used together.

Michael Brill Technology startup exec focused on AI-driven products

September 1st, 2014

it sounds like this is a very small debt financing that may be followed by a larger one before an equity round. Unless it's explicitly a follow-on to this first financing then pay attention to what you think that next deal will look like. Let's say you have no cap and a 20% discount now... and this first investor money gets you to a milestone where you do another convertible note. Then let's say the next investors reasonably want a cap - already the first investors are worse off. You can try to drop the discount, but then it's not fair to the new money and they may balk. And if you're willing to throw the existing investors under the bus then that also sends a strong, negative message. Optimizing for today can make tomorrow much more difficult.

It depends how you roll, but if you acknowledge that this first money is really inconsequential to your long-term equity position you may want to propose a lower cap now and raise the cap when more money comes in

Anat Baron Entrepreneur, Keynote Speaker, Filmmaker, Disruptor, Problem Solver, Human Sponge and Creative Thinker

September 19th, 2014

Jon Bassett Venture Capitalist and Entrepreneur

September 19th, 2014

For investors, the benefits of an uncapped note are virtually non-existent. The two scenarios I can think of are either 1) a friends and family round where your friends and family do not want to engage in a tough negotiation with you and would rather punt on valuation to keep a relationship happy or 2) a situation where there is so much demand for your deal that investors are clawing over each other to get into your deal and you can get enough interest on an uncapped note.

For founders, an uncapped note potentially gives you more time without setting a valuation. With the additional time and runway, you can continue to build your business and generate more revenue and traction which could drive a higher valuation in subsequent rounds of financing. 

The main issue with convertible debt (notes) is that they can cause mis-alignment between founders and investors. Investors will likely want a lower valuation in subsequent rounds so that their note converts into a larger equity stake in the company while founders are going to push for as high of a valuation as possible to decrease dilution. This can lead to issues in future financings. 


September 19th, 2014

A quick note regarding Mark Suster's post from Anat:

While it is true that uncapped notes are not good for investors when compared to other options, they are great for investors if they have no other way to invest in a promising company. All of Mark's opinions assume that there are alternatives, but if you have a very strong company investors will invest on whatever terms necessary to get involved for later financings. They would rather invest in an uncapped note in the next SnapChat than a capped note in the next Clinkle.

The challenge is demonstrating you have the promise to justify the terms you want. That means waiting until you can demonstrate real progress and traction before raising money. Today, many people raise their seed round based on an idea or a prototype which requires the investor to take a significant leap of faith. If they are taking a leap of faith, they likely won't agree to an uncapped note because it's too early to tell if you are SnapChat or Clinkle.

Trevor Wright Founding Partner at Dragon Garden Angel Investments

September 23rd, 2014

Can be fun to analyze options and all sorts of if/then scenarios but ultimately doesn't build your business.  Good to educate yourself on funding but don't over analyze the future - build your business and you will drive deal terms.

-Uncapped note great thing for entrepreneur. - provides future options
-Per your exact question: uncapped note would be better than high valuation but not worth fighting for if as you say it is a "high valuation".
-"high valuation pre-seed" as you state is great thing for entrepreneur

-all angels are different regarding valuation, key as entrepreneur is to set valuation that works for both.  You are going to have to provide a valuation that is attractive to the investor.  If it is at the stage of "too much art" in calculating the valuation then move toward "science" and do some research on average valuations for venture backed companies.  the data is out there.

-your final question about discounts in high valuation vs uncapped is unclear
-discount on a capped or uncapped note is more typical as it rewards the earlier guy that took more risk.

Michael Brill Technology startup exec focused on AI-driven products

September 1st, 2014

Could you clarify? You have no valuation pre-seed... and from the sound of it, if you are offering a discount on a future (e.g., Series A) financing with or without a cap, and the seed investment is coming in as convertible debt then you still have no valuation.

Sati Hillyer Looking to Hire a Ruby Engineer to join OneMob - 2015 Gartner Cool Vendor for CRM Sales

September 1st, 2014

We were given a note/term sheet with a valuation cap, but it's quite high.

I'm looking to raise a small seed from a couple angels first and want to know how to best leverage this term sheet. But thinking it's probably better to just offer them an uncapped note with a discount to keep things simple.

Hope that helps.