Cap or a Discount? Why it Matters
As moment-of-inception investors, we often participate in convertible notes or SAFEs. These allow early-stage investors to support companies at a point too early to know their real market value. The price is only established when the note converts into shares at a future financing round.
Notes and SAFEs have a long established structure. The investment converts at a cap value. If the cap value is $3M, and the next round’s valuation is, say, $5M, the early investment converts at the cap, $3M. If, for whatever reason, that cap value isn’t reached at the next raise, the investment converts at a discount to the round price whatever that is, generally 20 OR 25%. So, if the cap is $3M and the next round valuation is $2M, the note converts at $1.6M, 80% of the actual round valuation.
It is a good system. It works for both investors (by getting them some benefit for taking the risk of backing the company early) and the entrepreneur (by providing early capital in a flexible fashion that moderates dilution).
Lately, however—largely due to the latest policies from some accelerators who already have their investment stakes set through the company’s participation in their programs—we are seeing Notes and SAFEs with no option for a discount.
We think this is a terrible idea.
Essentially, in these cases, the investor is being asked to take on greater risk in support of the company with no benefit. That is unfair, and in our view, wrong.
Notes and SAFEs without discounts create the potential for unnecessary conflict between investors and entrepreneurs at the time of first financing. Consider a company where the SAFE has a $5M cap and the next round is only at a $3M valuation.
The no-discount argument says early investors don’t lose because they will simply wind up paying the same share price (at a $3M valuation) as all other investors. But early investors actually do lose in that scenario. Their risk was greater. Their money has been in the company for months. But their price is the same as johnny-come-lately investors who took none of that risk and weren’t there for the company when its need was greatest. That is out of whack.
And the actual situation can be even worse than that, potentially. A down round indicates issues in the company’s growth. Consider if the new investor, sensing that weakness, not only says the round is at $3M, but that the existing SAFEs must convert at the full cap value as part of the pre-value of the round. That means the early investors are compelled to pay a higher price than new investors and are then diluted in the new round. By being early supporters of the company, investors are actually punished in this scenario. This is the kind of scenario that can provoke bar fights.
The presence of a discount in a Note or SAFE completely eliminates these problems. The cap means the company knows the highest value of conversion. The discount means the investor knows there will be at least some recognition of the risk of coming in early, if everything doesn’t go as planned, and we all know they often times don’t. That's why the current structure has held up so well for years.
A positive spin on this current no-discount trend is that it stems from a misunderstanding by entrepreneurs of what a note discount is. They worry that it is a discount on the actual cap value. Of course, it isn’t. Cap and discount in a Note or SAFE are discreet alternatives to one another. The cap value never changes. The discount only applies when the cap value isn’t reached.
The less charitable view is that the elimination of the discount in Notes/SAFEs is a cynical power grab, pure and simple. It derives from a belief that early rounds in hot companies can so inflame investor passions that they will jettison common sense to get in.
We won’t play that game.
By Managing Partner Mike Edelhart