When discussing a convertible note or equity instrument, some important terms matter to both the investor and the entrepreneur. In a previous article, we discussed the differences between convertible debt and simple agreements for future equity (SAFEs).
This article talks about key terms in these instruments. It covers the valuation cap and the discount. It also explains other important terms like maturity date and interest payments.
There are two key terms in a convertible security that are often heavily negotiated during a deal: the cap and the discount. These are important terms that affect how these securities convert into stock. This happens during a future financing round.
In a convertible note or SAFE, the valuation cap sets the maximum company valuation at which the investment converts into equity. If the startup’s value goes above the cap in a priced round, the investor converts at the cap instead of the valuation for the round. As such, they convert at a lower stock price and receive more shares.
Example: A startup issues a note with a $6 million cap. Later, it raises capital at an $12 million valuation. Thanks to the cap, the investor’s note converts as if the company were worth $6 million, meaning they get shares at half the price paid by new investors.
Caps typically range between $4–20 million, which is quite a wide range which depends on the startup’s stage and market conditions.
As of the date of this article, the most common cap used is a so called “post-money valuation cap”. Under this type of cap, the startup is essentially selling a percentage of the company roughly calculated as the investment amount divided by the valuation cap. So if an investor invested $600k on a $6 million post-money valuation cap, the startup is essentially selling 10% of the company.
The discount is another incentive for early investors who provide capital when risk is highest. It allows the investor to convert the note at a discounted stock price compared to the valuation paid by later investors during the conversion event.
Example: A $100,000 SAFE has a 20% discount. If the price per share in the next priced round is $10.00, the investor converts at $8.00 per share and would receive 12,500 shares (calculated as investment amount divided by price per share).
Discounts generally range from 10–35%, with 20% being a common discount. However, it is worth noting that discounts are less common than valuation caps in most cases.
Most convertible investments specify that the investor receives shares at the lower of the price determined by the valuation cap or the discount. This ensures the investor receives the best possible terms when the investment converts (and it is important to note that the investor does not get to apply both the cap and the discount).
Example: If a note has both a 20% discount and a $6M cap, and the price per share in the priced round is $10.00:
Beyond the cap and discount, here are several additional key terms:
A Simple Agreement for Future Equity (SAFE) is one form of convertible equity commonly used in early-stage financing. SAFEs have no maturity date and don’t accrue interest, which can make them more founder-friendly while still providing upside for investors.
Unlike convertible debt, SAFEs don’t create pressure from repayment or accumulating interest, but they still offer similar upside via conversion into equity at a discount or cap during a future priced round.
Using convertible securities to raise capital can benefit both sides:
It is important to understand the key terms of convertible debt, a SAFE, or other types of convertible equity. These terms include valuation cap, discount, maturity, and interest. Understanding them is essential for protecting your interests and making a fair deal.
Want help structuring your convertible securities or raising your next round? Get in touch with us to talk through your options.