Valuation Caps in Convertible Note Financings

Over the last couple years I have noticed an upward trend in the use of valuation caps in convertible note financings.  Valuation caps enable investors to capture more upside in the event of a higher-than-expected pre-money valuation in the next round of equity financing.

For example, say an angel investor group buys $1 million of convertible notes that (i) convert at a 15% discount to the price per share in the company’s preferred stock financing and (ii) have a $4 million pre-money valuation cap on such preferred stock financing.  The company later signs a Series A term sheet for a $10 million investment on a $10 million pre-money valuation (so the company will be worth $20 million post-financing).  There are 1 million shares outstanding prior to the Series A financing so the price per share of the Series A preferred stock to the new investors would be $10.

Had the noteholders only had a 15% discount they would convert into Series A preferred stock at $8.50 per share (15% * $10 = $8.50).  At that price they would receive 117,647 shares of Series A preferred stock, which would represent approximately 5.9% of the company post-financing.  However, since the pre-money valuation for the Series A financing is greater than the valuation cap built into the convertible notes, the $4 million pre-money valuation cap comes into play and the noteholders convert at $4.00 per share ($4 million / 1 million shares = $4.00 per share).  At $4.00 per share, the $1 million of convertible notes convert into 250,000 shares of Series A preferred stock, which represents approximately 12.5% of the company post-financing.

The use of a valuation cap in this scenario yields a 6.6% post-closing swing in ownership in favor of the holders of the convertible notes.  The valuation cap concept in convertible note financings is a an investor-favorable provision that should be examined closely by both sides in the financing before being agreed upon.

This post on Financing Strategies was authored by Ian Engstrand.


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