Setting the Right Cap for a Pre-Rev Startup's Convertible Note

Convertible notes are a popular form of financing for startups that have yet to reach revenue (pre-rev). These notes are essentially loans that convert into equity at a later date, often after the company has secured a more substantial funding round. This article will guide entrepreneurs and investors through the process of setting the right cap on a convertible note for a pre-rev startup, with a focus on angel and seed investment rounds.

Understanding the Key Concepts

Before delving into the specifics of setting a cap, it is essential to understand the fundamental terms of a convertible note. A convertible note is a short-term loan that a startup receives from investors, offering the option for the note to convert into equity at a later date. The cap is a predefined ceiling within which the equity conversion occurs, limiting the amount of potential equity that the investor receives if the startup is valued above a specified figure. The cap is often paired with a discount to the next round, which provides investors with an additional discount on the priced round's valuation when the note converts into equity.

Common Scenarios with Convertible Notes

When considering the cap, it is useful to understand the common scenarios that can occur:

1) The company goes out of business before the note is due (80%). 2) The note comes due, and the company is not worth the cap amount (15%). 3) The note comes due, and the company is worth the cap amount (4%). 4) The note comes due, and the investors get a break, converting at the cap amount (1%).

Calculating the Appropriate Cap

The average SAFE (Simple Agreement for Future Equity) note is structured as a 500K loan at a 5M valuation with a 20% discount to the next round. While there is no one right or wrong answer, the key is to ensure that the terms are fair and that investors are willing to commit their money.

Step-by-Step Process

Review your financial projections. Identify a viable estimate of your company's valuation at the end of the note term, which is typically around Year 2. Take a look at your annual revenue run rate, last 3 months' revenue, and EBITDA. If you lack a financial advisor, consider getting one.

Estimate what your company would be worth if you were trying to sell it in this future year. Use online resources to look up comparable companies in your industry or technology space, even if your company is unique.

Apply a realistic discount to the next round valuation. For example, with a 20-30% discount, a company valued at 8M in two years would translate to a present valuation of 6.4M to 6M.

Start pitching to raise money. Be prepared to explain how you arrived at the valuation and remain flexible with terms until a lead investor is found. Most terms should be within 33% of your starting point.

Adjust your cap based on market feedback. If you are significantly over or underpriced, you may need to revisit your projections and assumptions.

Once a lead investor is secured, finalize the deal and continue pitching to fill the remaining note.

Conclusion

Setting the right cap for a convertible note requires careful consideration and an understanding of the market conditions and investor appetites. By following the outlined steps, startups can craft a cap that balances the needs of both investors and the company, paving the way for a successful fundraising round.