Troll the web on this subject and you’ll find a trove of information on the subject of adding a cap feature to an angel’s convertible note. (In fact, Dave's blog from a couple of days ago touches on this very subject! - Not planned I promise)  I recently had the opportunity to analyze this in the context of a deal and here’s my 2 cents of insight to add to the mix.

What cap am I talking about?:  Most angel and seed investments in a start-up are structured as convertible notes that accrue a nominal (sometimes more) interest over a set amount of time.  These usually convert into the equities sold during a following venture round at a set discount to the price that the venture investor pays for their shares.  See my earlier post on friends and family financing where I extol the virtues of the discount rate as a just reward to the people who invested in your company when it was far too risky for any venture financing.  However, although the discount rate does reward your seed and angel financers, it only does so to a certain point, and does not, by itself, fairly share the riches in a rags to riches phenomena.  This can give rise to a quirky disincentive for early stage investors not wanting the biggest pre-money valuations for the companies that they invested in. 

Ok here’s an example:  Joe starts AwesomeCo.  Joe issues himself 1 million shares and he is the sole stockholder of the AwesomeCo.  Angela is impressed with Joe and AwesomeCo’s business plan and invests $100,000 in AwesomeCo via a convertible note that will convert into the equity sold during the first venture round at a price per share that is 20% less than the price per share that a venture company would pay for those same shares. 

Scenario 1:  Several months go by and Joe making good use of Angela’s seed money makes some important advances in his company’s business.  BigMoney, a VC firm, is introduce to Joe by Angela.  They are impressed with Joe and AwesomeCo’s success and they see it as the company of the future.  They put a pre-money valuation of $10 Million dollars on AwesomeCo and decide to invest $2.5 Million in the company ($10/Share of AwesomeCo’s preferred A stock).  The end result, BigMoney owns 250,000 shares of series A preferred stock of AwesomeCo and Angela owns 12,500 Shares or 0.99% of the total company after the conversion of her note at the 20% discount (or $8/share).  That amounts to approximately $123,750 dollars in perceived value of Angela’s portion of the company.

Scenario 2:  Assume the same transaction, except in this case assume that BigMoney had a pre-money valuation of $2 Million dollars and only invested $500,000 ($2/Share of AwesomeCo’s Preferred A stock).  In this scenario Angela’s $100,000 note will convert into 62,5000 Shares or 4.7% of the total company which is approximately $117,500 of the company.

Given the two circumstances, which would Angela prefer?  In both cases she is getting to convert her shares at the set discount rate.  However, in Scenario 1 the high pre-money valuation results in her getting heavily diluted and not getting to share in the company’s success story past her initial 20% discount rate.  She does end up with more value after the larger deal ($6, 250 or 5.3% difference), in a deal where the value of the company has gone from nominal to 10+ million dollars.  In effect for the 5.3% difference in perceived value, she is going from a large stake holder to an insignificant one.  Why should she get a better deal?  Angela could argue that her grant of seed capital made it possible for the Joe to build upon his business plan, which in turn made it possible for him to have this fantastic first round of financing.  She would argue that though both Joe and her come out on top, she doesn’t really get to share in his home run and she isn’t sufficiently compensated for their giant success.  In some perverse way, one could imagine that it actually might make her adverse to signing an a high pre-money valuation and the resulting large VC round of financing.  She might even not be willing to sign a convertible note to begin with.  From Joe’s perspective, he could argue that even if Angela is being diluted she is going to end up with a smaller piece of a bigger pie which means more value to her.  They might come to dead-lock over this.  How do we solve this quandary?  One answer, insert a cap provision in the convertible note.

The cap provision allows the angel investor to share in a home run success of their investment companies further down the investment chain and protects them to some extent from the resulting dilution.  Instead of only having the ability to convert their notes into the next round of equity at a fixed discount rate, the investor can now set a maximum price per share that the angel will have to pay in the event of a qualified financing by pegging the maximum price to an imaginary cap to the pre-money valuation.  In the event of a financing and resulting conversion of the note, the lower price per share resulting from either the cap provision or the discount would prevail in determining the conversion price.

I hate explaining mathematical equations in prose so here is an example using our cast of characters.  Angela’s note to AwesomeCo has both a 20% discount rate and a cap provision that says that the conversion price into the company’s next round of financing would be capped at pre-money valuation of $5 Million dollars.  Hence, the conversion price of her note would be the lower of either the 20% discount rate or the price per share she would have paid at a $5 Million pre-money valuation (if needed).  With this in mind, let’s run through our scenarios again. 

Scenario 1 (with cap): with the $10 Million pre-money, the $5 Million Pre-Money Cap would kick in to reduce the conversion price to a maximum of $5/share.  Choosing the lower conversion price of $5/share (since using the discount rate would get us a conversion price of $8/share), Angela would own 20,000 shares (compare to 12,500 without the cap) or 1.5% or $187,500 in perceived value (compare to .99% or $123,750 without the Cap) of the company.

Scenario 2 (with cap):  Due to the pre-money valuation of $2 Million, the cap would not come into play and the equation would remain the same. 

What the Cap is doing in effect is acting as a security blanket to the angel investor and providing them with some assurance that even if they get heavily diluted in the event of a large pre-money valuation, they still to some extent get to share in the success of such a round.  A cap might not be an effective or required strategy for all angel investments and there are many variations of the above equations.  Also, the inclusion of a cap at the strong insistence of an angel can allow the entrepreneur to negotiate on other terms in the note.  Some lawyers I have spoken with think the cap is too greedy and would prefer to see something more like a warrant for a fixed number of additional shares at the set Preferred A price (but more on that later).  There are a dozen different ways you can slice and dice this, but at the end of the day talk to your lawyer to see what makes the most sense for your company or investment.