By: Paul A. Jones
Convertible debt with an equity kicker, typically either in the form of warrant coverage or a discount on the conversion rice, is a common vehicle for seed stage financings. As people on both sides of these deals have become more familiar with the convertible debt structure, a number of bells and whistles have begun popping up. One twist is the notion of a cap on the conversion price of the debt. As of today, valuation caps are included in most West Coast convertible debt deals, and are becoming more common in the Midwest.
While valuation caps may be here to stay, entrepreneurs and investors alike should understand when and how a valuation cap might negatively impact downstream financing.
First, it is probably worth asking why the “market” seems to be moving towards the regular use of valuation caps. The answer is that the same market seems to have settled on an equity kicker in the 10%-30% range: that is, whether the kicker is in the form of warrant coverage or a discount on the conversion price the effective kicker in most convertible debt seed rounds is somewhere in the 10%-30% range.
Assuming a very common 20% for the kicker, what is the problem? Why, with a 20% kicker, should a seed investor also want a capped conversion price? Two situations come to mind, the first understandable but ultimately not very persuasive, and the second understandable but somewhere out there in “what would you do if you won the lottery?” land.
In the first case seed investors use the valuation cap to try and end run the 10% to 30% market price for the convertible debt kicker. And for good reason. Be honest, here, Ms. Entrepreneur: capping a seed investor’s return at 10% to 30% from the seed round to the A round is pretty, well, parsimonious. Considered in this context, the point of a valuation cap, from the investor’s perspective, is to juice the return. The idea is to get a cap below the likely A round valuation, so that the cap will have the effect of juicing the kicker on the seed debt.
Assuming juicing the convertible debt kicker is the point of the cap, what is the problem? Well, the same problem that would exist if in the alternative you just bumped the basic kicker from the 10%-30% range to say the 50%-100% range. The extra juice would likely be too much added dilution for the A round investors to accept. A round investors can generally live with seed kickers to the extent they, at least in terms of optics, don’t seem to undermine the fundamentals of the A round price. But when a kicker starts changing the fundamentals of the deal – that is when the seed round is either too large (say more than 1/3 the size of the A round) or the kicker too big (say more than 30%) – the dilution from the seed round at conversion begins to look more than marginal and the A round investors will likely start pushing back.
The second, and I think much more convincing, rationale for a cap on the convertible debt conversion price is the “what if we win the lottery?” scenario. Here, the point of the conversion price cap is to protect the investor if the A round price ends up being far beyond what either the seed investor or the entrepreneur might reasonably have expected when the seed round closed. So, for example, consider the typical situation where a seed investor puts in $100k with a 20% kicker, on the assumption, shared by the investor and the entrepreneur, that if the deal goes well the A round will be priced at, say, $3-5 million pre-money. What happens if, between the seed closing and the A round the entrepreneur catches a venture capital thermal and suddenly finds herself looking at an A round pre-money north of $15 million? In this scenario, the point of the seed conversion price cap is to make sure that the benefits of the unexpected windfall are shared by the seed investor as well as the entrepreneur. And I think, at least, that such sharing seems entirely appropriate.
That leaves one question. What, in general, is a “fair” conversion price cap? Given that the “good” rationale for a conversion price cap is to share an A round valuation windfall, the question becomes what constitutes an A round windfall. I don’t know that there is a “right” answer to that question, but my sense is that it is twice what the seed investor and entrepreneur reasonably thought the upper end of the A round price range would be at the time of the seed round. In the example in the prior paragraph, that would be $10 million.