The Convertible Debt Valuation Cap - Part I: The Trigger Financing Investor Perspective

Today, Part I of a series on a somewhat esoteric – but important – seed financing issue. Conversion valuation caps in convertible securities seed financing transactions.

(A preliminary note. This topic is a bit more math-driven than most. Further, in order to preserve my sanity and time, my models ignore some of the finer complications of modeling conversion valuation caps. My models are illustrative, but include some “shortcuts” that while real are more noise than signal, from a big picture perspective. If anyone out there in blog land thinks I’ve missed something more signal than noise, you know how to reach me.)

Convertible debt/equity (for convenience, I will refer to both – including SAFEs - as convertible notes) can be a cheap, simple solution to a common seed financing conundrum: mismatched investor/entrepreneur thinking about valuation. Punting on valuation makes for a simple and facile negotiation. Simple is cheap, too, and given the traditional small size of these deals that’s surely another attraction of the structure.

Unfortunately, as the years have gone by, investors (aided and abetted by too compliant entrepreneurs) have started employing convertible notes in larger chunks, and using them to finance longer periods of time. Both developments magnify flaws in the convertible structure. In turn, various band aids have been affixed to convertible notes that address those flaws.

One such band aid is the so-called conversion valuation cap. A conversion cap of say $5 million provides that if the “trigger” financing (the financing that triggers conversion of the note) is at a pre-money valuation greater than $5 million, the convertible note will convert at a price per share calculated as if the pre-money valuation of the trigger financing was $5 million. The cap is designed to protect the note investor from a situation where the trigger financing valuation far exceeds what either the note investor (or the company) expected when they closed the note investment.

To understand the issue here, consider a couple of scenarios, or rather several variations on a scenario.

The scenario is this: Newco is offering a convertible note with a 20% discount and a $5 million conversion cap (just to keep the math easy, let’s assume there is no interest on the note). Newco anticipates a subsequent trigger financing round of $3 million new money in Series A preferred stock with a 1x participating preference (so that on an exit transaction the Series A stockholders get their investment back first, and then share remaining proceeds pro rata with the common stockholders on an as-converted-to-common basis). In fact, that trigger round happens at a valuation of $15 million pre-money. Coincidentally (or, quite plausibly, by design), the price per share in the round – keeping the math simple – is $1.00. Finally, and again just to keep the math simple, let’s assume eventual exit proceeds equal to the total (New A Money plus Note A Money) preferred liquidation preference with the conversion cap in place.

In Variation 1, let’s assume that the convertible note financing totals $50,000. Let’s call it (for reasons that will reveal themselves in due course) the “Dog (the New A Money) Wags Its Tail (the Note A Money)” variation.

Table A

OUTPUT (1X LiqPref: Note Val Cap)	$$$ Invested	Exit $$$	Return X
Note Pfd	$50,000	$187,500	3.75
New Cash Pfd	$3,000,000	$3,000,000	1.00

The answer to the “So what?” question in this Dog Wags Its Tail variation is that while the “kicker” for the Note investors is quite large in percentage terms, – the Note holders end up with 3.75x as much equity/preference as they paid for – in absolute dollar terms it is pretty small. Yes, Note A Money investors record proceeds on the exit of $187,500 (3.75x their investment), while the New A Money investors only breakeven on their $3 million investment (1x their investment). But, in the greater scheme of things, the New A Money investors – the Dog – got their $3 million back. The $137,500 “bonus” gain for the Note A Money – the Tail – is, if not immaterial, surely more insult than injury to the New Money A investors.

Staying with Variation 1, note that if there was no valuation cap, the bonus liquidation preference for the Note A Money investors would be just 1.25x ($62,500/$50,000) - just $12,500 in the aggregate. An even less significant trifle from the New A Money investors.

Table B

$$$ Invested	Exit $$$	Return X
Note Pfd	$50,000	62,500	1.25
New Cash Pfd	$3,000,000	$3,000,000	1.00

The bottom line on Variation 1: the “cost” of the valuation cap to the New A Money investors when the Note financing is a small fraction of the New A Money investment (in this scenario just 1.67%), is just noise in the system, even with the valuation cap.

Now let’s look at Variation 2 – the Note Tail Wagging the New Money Dog scenario. The only difference from Variation 1 is that the Note A Money investors put in a total of $1 million rather than $50,000.

Table C

OUTPUT (1X LiqPref: Note Val Cap)	$$$ Invested	Exit $$$	Return X
Note Pfd	$1,000,000	$3,750,000	3.75
New Cash Pfd	$3,000,000	$3,000,000	1.00

Consider that the Note A Money investors are now getting $3,750,000 in proceeds against just $3,000,000 for the New A Money investors. A buck a share to each, though the Note A Money investors only paid an effective $0.27 for their shares. The Note A Money investor liquidation preference stays at 3.75x as in the earlier scenario, but the dollar value of their total preference is now $3,750,000. Hmmm: if I am a New A Money investor, I am not a happy camper. I’ve broken even on my $3 million investment, and the Note A Money investors received a 375% return on their $1 million investment: even though we bought the same A stock.

Again, staying with Variation 2, let’s look at the case where there is no valuation cap.

Table D

OUTPUT (1X LiqPref: Note Uncapped)	$$$ Invested	Exit $$$	Return X
Note Pfd	$1,000,000	1,250,000	1.25
New Cash Pfd	$3,000,000	$3,000,000	1.00

The bonus liquidation preference for the Note A Money investors is now 1.25x – just as it was in the no note cap situation in the $50,000 Note scenario. But, with the $1 million Note that works out to $250,000, instead of $25,000. The damage to the New A Money is real, but limited to the Note investor’s bargain (a 20% discount on conversion) or, in effect, $0.80 paid for each Series A share that the New A Money investors paid $1.00 for.

One final data point. As you add to the preferred liquidation preference – say, for the example below, you go to a 5x cap – the additional exit proceeds going to the converted note preferred shares grows at the same 3.75x rate: which is to say the “pain” of the extra preference is born by the folks in line after the preference is paid – the commoners, so to speak (more on that next time). Here’s an example (Table A and B with new assumption of 5x participation preference).

Table E

OUTPUT (5X LiqPref: Note Val Cap)	$$$ Invested	Exit $$$	Return X
Note Pfd	$1,000,000	$18,750,000	18.75
New Cash Pfd	$3,000,000	$15,000,000	5.00
OUTPUT (5X LiqPref: Note Uncapped)	$$$ Invested	Exit $$$	Return X
Note Pfd	$1,000,000	1,250,000	1.25
New Cash Pfd	$3,000,000	$3,000,000	1.00

I’ll confess that I started this exercise a bit unsure how it would come out. More particularly, I had seen a lot of noise out in the market suggesting that convertible valuation caps tended to set caps for the A round valuation as well. I was a bit skeptical of that, or at least curious. Having gone through this process, I am considerably less skeptical.