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Because it 'protects' against a company raising say 1m on notes, and growing to a 30m valuation series A. You also get the debt preference in case of acquihires

• gumby 11y ago
  > Because it 'protects' against a company raising say 1m on notes, and growing to a 30m valuation series A. You also get the debt preference in case of acquihires and early exits. Good point about the acquihires, which is a case I hadn't thought of. But for anyone building a real business I only see it as a disadvantage. Consider three scenarios: 1> angels get equity (series "pre-A"). Set a price. Now the next round values the company at 30M pre -- they get a small chunk of a company worth a lot, and that has a good chance of being worth a lot more in future. 2> Angels don't set a price: Now the next round values the company at 30M pre -- they get a 20% larger chunk of a company worth a lot, and that has a good chance of being worth a lot more in future. 3> Angels put a cap which has now become a de facto price, say 10M. Now the next round values the company possibly at 30M pre -- but especially due to the "anchoring" effect of having a number out there it's maybe 20 pre. They get perhaps more of a smaller company, and the founders get diluted more (since the new investor still wants their percentage -- the growth comes out of the founders' hide. This creates a conflict of alignment between the note holders and the founders. These caps are typically unheard of on bridges and other debt instruments companies take on later (except for dying companies) because the preferred shareholders know full well how destructive they are. So why subject the founders to these terms. Because they are naïve and you know you can get away with it? > For institutional investors, all they now only make the discount return on the note, while for an angel, well all you get is to participate at the series A. All kinds of entities get the same terms on the note. Both get the discount. > Bad for the company, great for investors. Yes, that's precisely how I see the cap.
  • diziet 11y ago
    > angels get equity (series "pre-A"). Set a price. Now the next round values the company at 30M pre -- they get a small chunk of a company worth a lot, and that has a good chance of being worth a lot more in future. And now angels can say they turned $100k investment at 5 post cap into $600k, where as with case 2 they only get a larger chunk. > All kinds of entities get the same terms on the note. Both get the discount. Yeah, I understand the the terms are the same. I mean that a year in, on an uncapped note both institutionals and angels can't go to their partners/friends and say "We put in $100k into XYZcorp, and now they raised a series A and our stake is worth $2m". They only get to make 25% gains from the discount. Capped notes are ideal for investors, the money amount is too small to justify board involvement from them, so the note sidesteps that while possibly having the best liquidation conversion/ratchet/debt structuring. Capped notes are what everyone wants to see put in place on top of the companies that might turn into unicorns, but they give investors insurance of sorts for lower exit events.