A Twist on Convertible Notes
Transcript
So last week we talked about convertible debt and how important it is to think one or two moves ahead. I have one more piece I want to talk about. This will probably be the last time we'll talk about debt for a while. And that is how do you appropriately put a cap on debt when it's a short term vehicle, a bridge to your next round, which is frankly what convertible debt was originally set for. So if you think about it, if you have, let's take the example from last week where you had raised $1 million on a $4 million post-money
valuation and you're doing a round to bridge you well if you set the cap of that bridge too high
then you're signaling to investors that you think this company's worth a lot of money today
when you go to close on your next round in six months they'll look at that and if it's too high
one of two things is going to happen either they'll say oh that's too rich for my blood
too high a price or they'll look at it and say i think it's worth less than that i'll make them an
offer but wait a minute i don't want to invest in a company whose value is going down so there is
risk in putting too high of a cap the perception is that the value of the company is going down
if you set the cap too low there's also risk in that you are then signaling what you think the
value of the company is and that they are going to make their offer based anchoring on that low price
and so wouldn't it be cool if you could use convertible debt as a vehicle for a bridge
without signaling price so one way you could do that is have an uncapped note where that note
will just get a 20 discount on the next round the challenge is there are a lot of investors who
don't like an uncapped note because it's giving money with no cap on how big that could be and
it's a little uneasy from this side writing that check but there's an interesting thing that i've
seen happening recently and that is what i call a midpoint note the price on the note the price
that it will convert at is the midpoint between your last round's post-money valuation and the
pre-money valuation of the next round so think about it what's happening is the new investors
who are bridging you get a better price that price is exactly the midpoint between the last round and
and the next round. Sounds fair. The new investors are coming in and there is no signaling of price.
There's not too high of a cap. There's not too low of a cap. They have to tell you what they think
the market thinks your company's worth. And whatever that is, your bridge investors will
get a discount based on how much progress you have made. So it's a fascinating thing to think
about. And I've seen more of them recently. And I'd encourage you to think about it as a way to
build your bridge without having an uncapped note and without signaling price.
While some entrepreneurs like uncapped notes, most investors hate them. But agreeing to a valuation cap can send a signal that may hurt you in your next round – it could be too high, scaring off potential investors or too low, hurting your negotiating power. Here is a way to raise this bridge with a price the investors will like without signaling any price at all!
Originally published on the MATH Venture Partners blog.