Convertible notes can be somewhat confusing, and learning the terms under it can lead to even more confusion. Convertible note caps tend to be highly beneficial to those involved, but understanding them can be highly tricky.
Convertible note caps are the maximum valuation that an investor may receive based on the original valuation cap agreed upon. These caps were created to protect the investor from being penalized later on
Convertible notes, and their caps, can be somewhat confusing to understand fully. Not only is it essential to understand convertible notes, but you must understand how the valuation of startups works as well as how stock typically works. Keep reading to find out how convertible note caps work.
What Are Convertible Note Caps
Convertible note caps are set so that the investor is protected if the first priced equity round is a higher value than expected. This was created due to early investors stating the discount doesn’t fully compensate for the risk they took at the beginning.
For example, imagine an investor invests $200,000 as a convertible note with a valuation cap of $10 million then even if the company rises to $20 million valuations. The investor wouldn’t rise to the $20 million valuations, but rather the $10 million cap that was agreed upon.
Thanks to the cap, these early investors pay half the price the newer investors pay. They will also be receiving double the shares, unlike the new investors. This is a great incentive for investors to invest early rather than wait to see if others will invest as well.
What Is A Convertible Note?
Before fully understanding how a cap works, you must first have a full understanding of what a convertible note is. This can be a somewhat confusing term for any who may not have had to deal with them before.
Financing A Startup
Typically, a convertible note is a loan from investors to a new startup. This is a short-term debt that will eventually convert into equity. This is usually in the form of the investors’ preferred stock, rather than paying the money back with interest.
However, the convertible note will typically only be paid back as a preferred stock if the company raises an equity round. Otherwise, the debt must be paid back with interest stated originally.
This is a popular method with startups that an investor may believe has the potential to grow. By using a convertible note, both parties will benefit in their own ways.
Why Not Common Stock?
Depending on the investor, they may not accept shares of common stock. Most sophisticated investors will want preferred stock over the common stock, which is due to several reasons that I will discuss more below.
Valuation Of The Startup
The first problem with using common stock instead of preferred is that it can be difficult to agree on the percentage the investors will receive. This is also a risk for the founders, mainly due to the possibility of dilution over time.
If investors are paying substantially more for a common stock than others, like the founders, the IRS may put a much higher value on the shares. This mainly means that the excess that the investors paid would be considered taxable income for the founders.
If the founders give the investors shares of the common stock, then that would set the value of the common stock. It is best to keep the price low to incentivize others so they can benefit from the company’s growth as well. The high price from the investors would make that goal nearly impossible.
Why Should You Issue Convertible Notes?
There are many pros to issuing convertible notes over a normal loan with interest. This is a highly beneficial deal for both the investor and the founders. This is especially true if the startup is successful. Otherwise, the investor may not benefit as much.
One of the biggest pros is that the valuation issue from above can be avoided until later on. It will usually wait until the Series A round of financing, which usually means there are more data points at this time. It makes it easier to value the startup as it should be, which is highly beneficial.
Simple And Easy
When I say that convertible notes are simple and easy, this is mostly in comparison to other standard loans. This loan can be closed with a day or two by issuing a two or three-page promissory note. This is much cheaper to do than dealing with the legal fees of negotiating the issuance of preferred stock.
This method is also recommended is because it avoids giving the investors control over the company. Most preferred stockholders tend to have seats on the board and have the power to veto certain items. They have much more power than an ordinary stockholder would, which can be dangerous for the founders.
Unlike them, convertible noteholders will not typically have as much power over the company. It is more common for them to have minimal, or none at all, control granted to them. Most noteholders will make up perhaps 4% of the seed financing, while preferred stockholders tend to make up 70%.
As I mentioned previously, the cap is highly advantageous to the investors due to it protecting them. This is due to the ‘ceiling’ on the conversion price, which allows them to share in the benefits if there are any significant increases in the value of the startup they invested in.
The most important part of the cap is it is not a valuation for tax purposes. This is largely why investors will get different caps, which is different from a priced round.
This is beneficial to any investors since you are lending money to a company. Even if you are using convertible notes, they will also gain interest over time. This doesn’t typically result in cash, but rather in the number of shares once it is converted.
As I mentioned briefly above, all convertible notes have a maturity date. This basically means that if a convertible note has not been converted to equity by said date, then the company must pay the investors.
Some convertible notes have an automatic conversion once they have reached maturity. This isn’t true for them all, so it is important to make a note of this.
Conversions typically happen when the equity investment exceeds a certain point. This means the investor will get the benefit of gaining more shares than if they had waited to invest. Early investors also tend to get more perks, like conversion discounts and the note cap.
Why Preferred Stock Over Convertible Notes?
There are various reasons an investor would want to preferred stock over convertible notes. One of the reasons I mentioned above is highly important to keep in mind. Preferred stockholders have more control than a convertible noteholder would.
Just As Fast And Cheap
Over time new forms have been developed that make a priced round similar to a convertible note. When I say this, it means that the cost is just as cheap and can be just as quick as compared to issuing convertible notes.
Series Seed And Standardized Forms
The Series Seed and other standardized forms have replaced the complexity that involved a set of Series A documents. The previous method would take a full negotiation and a lot more work to achieve. These forms have simplified the issue, which allows more people to benefit from preferred stock.
However, the biggest issue with these quicker forms is that they are non-negotiable. This is the main issue with these newer forms and the main reason that many are still choosing the original method or convertible notes. There is much less flexibility, and most founders prefer to not use these forms.
It isn’t uncommon for investors to not receive a cap on their convertible note due to the founders attempting to maximize the valuation of their company in the Series A round. While the founders want to maximize it, the investors tend to want it minimized. This is due to investors being ‘penalized’ for helping the startup get a higher valuation.
It can be difficult for an unsophisticated investor to get a fair valuation, unlike sophisticated investors who are able to negotiate fair prices fairly easily. For unsophisticated investors, this can harm them in the long run.
Capital Gains Treatment
For noteholders, they must wait until the conversion date for them to start receiving long term capital gains treatment. Unlike noteholders, preferred stockholders will begin to receive this treatment immediately.
How Do Stocks Work?
The most important thing about convertible notes is that they are converted into equity for the investor. This is typically in the form of preferred stock. This means it is highly important to have a good understanding of not only the different kinds of stockholders but how the stock market works in general.
What Is The Stock Market?
The stock market refers to indexes in the stock market, such as the Dow Jones Industrial Average or S&P 500. These indexes exist due to the difficulty of tracking every stock available. This means they take a section of the stock market and use their performance to show the overall performance of the entire market.
When the stock market has moved, this is typically referring to these indexes and the stocks within them. If a stock gains or loses value, this will move the index. Investors will buy or sell stocks with these shifts in hopes of earning a profit.
How Does The Stock Market Work?
The stock market revolves around companies selling shares to investors, which helps the company gain more money. Investors can then either sell their share or buy more from the same or different companies. Most of these transactions occur electronically, which is beneficial due to the algorithm that will do most of the work of setting the price for shares.
How Do Investors Make Money?
Typically, investors will try to buy stock while it is at its cheapest in hopes that it will rise in value. However, there is a balance of knowing when the stock may drop, causing it to lose its value. Most investors will try to sell their shares when they believe a company is at the peak of its growth before it loses value.
These drops and rises can typically be tracked through a graphing system. By following the trends of the stock market, an investor may be able to guess when the next drop or rise will happen for a company. However, there is no sure way to know, and many have woken up the next day to find their stock has plummeted suddenly or possibly raised.
Preferred Vs. Common Stock
To fully understand the benefits of why most investors for startups want to preferred stock over common stock. This is especially important to any new investors, as it may be difficult to understand why most would prefer one over the other or what the difference even is. I briefly discussed both above, but I will go into more detail on the differences between these both.
Common stocks are the typical form of stock that someone would buy. When you hear someone talking about buying or selling shares in the stock market, it will usually be about common stock. This is the stock that the majority of people will invest in.
The biggest thing to note from common stock is that shareholders are able to vote. This means they have some sway of corporate policy and the management, like the board of directors. Typically, an investor gets one vote per share they have within the company.
This stock is said to provide the most potential for long-term benefits. As I mentioned previously, as a company does well, so does the shareholder. However, it is good to be aware that if a company performs poorly, then the stock value will go down.
The biggest downside to common stock is that it is the lower priority. Typically, common stockholders are the last for the company’s assets. This mainly means that common shareholders won’t receive these extra benefits until preferred shareholders have been paid.
The biggest thing to note about preferred stock is that it has a higher claim on the assets of a company than a common stock does. This is typically a common stock with extra features that investors would highly benefit from.
No Voting Rights
The biggest difference between the two shareholders, is that preferred shareholders don’t receive voting rights. They will have no say in the board members or the future of the company, which can be a huge factor for investors.
Like A Bond
A preferred share can be considered similar to a bond in some ways. This basically means that unlike common shareholders, preferred shareholders are guaranteed a fixed dividend. This amount is usually based on the par value before the stock is offered.
It is different from the commons stock that has variable dividends declared by the board and not necessarily guaranteed. Unlike common stock, preferred stock s affected by the interest rising or declining. This can affect the value of the preferred stock, unlike the common stock that is affected by demand and supply.
Assets And Earnings
As I mentioned above, preferred stockholders have a greater claim on the company’s assets and earnings in cases of liquidation. This is also true in cases when the company has excess and distributes the money through dividends, which are typically higher than those for common stock.
Preferred stock is usually wanted mainly due to the fact it has priority over common stock. This is important in cases where a company misses a dividend payment. Which means they must first pay the preferred stockholders before common stockholders.
The callability feature means that the issuer can redeem the shares after a time that is determined previously. Investors will have an opportunity for these shares to have a redemption rate that shows an extreme premium over the original cost of purchasing them.
The biggest thing to be aware of when considering convertible notes is the benefits and how they would suit the investor and founders. Typically, both parties will prefer convertible notes for various reasons, but it is good to be aware that these reasons can be slightly different and might cause some misaligned priorities.
Convertible note caps were created to benefit the investor, but it isn’t uncommon for founders to prefer there not be one. For an inexperienced investor, they could get a convertible note with no cap and later pay the penalty for doing so.
Along with being aware of convertible notes and their caps, one must be aware of how these notes fit into the stock market. This can get complicated and confusing for those who don’t have much experience with stocks, but the concept can be picked up quickly with some time and research.