Convertible Debt With A Cap: Understanding The Risk

Convertible debt with a cap, a common funding method for startups, can seem like a quick and easy way to secure financing. However, it often presents a hidden downside for founders: full ratchet anti-dilution provisions and multiple liquidation preferences. These terms, often overlooked, can significantly impact your startup's future and dilute your equity.

The Problem with Caps

A cap in convertible debt sets a maximum price at which early investors' debt converts into equity. While seemingly beneficial, this creates a situation where investors are essentially betting on a specific valuation. They are assuming their investment will be worth that amount, even if the company doesn't reach that valuation.

• If the company raises its next round at a higher valuation than the cap, the cap doesn't matter. Investors get a discount, and everyone's happy.
• However, if the company raises its next round at a lower valuation than the cap, the cap becomes a full ratchet anti-dilution provision. This means the early investors' debt converts at the lower price, diluting the founder's equity significantly.

The Full Ratchet

A full ratchet is a term sheet provision that protects early investors in the event of a down round. It ensures they receive a higher percentage of equity than they initially paid for. In a convertible note with a cap, if a down round occurs below the cap, the early investors' equity converts at the lower price, creating a significant dilution for the founder. It's like those investors getting a free ride on the company's future success.

Multiple Liquidation Preferences: A Hidden Danger

Convertible notes with caps can also lead to multiple liquidation preferences. This happens when investors' debt converts into equity at a later round with a higher valuation, resulting in a preferential return for those early investors. This creates a scenario where founders might find themselves giving up more of their equity to earlier investors than they initially intended.

Convertible Debt Versus Equity

While convertible debt seems faster and cheaper for startups, there are arguments against its widespread use. Many venture capitalists and lawyers recommend using equity financing as a more transparent and equitable way to secure funds.

Benefits of Equity Financing

Equity financing provides clarity from the outset. It involves a clear valuation and defines the equity each investor receives. This avoids potential pitfalls of convertible debt, such as full ratchet provisions and multiple liquidation preferences.

Alternatives to Convertible Debt With A Cap

If you decide to use convertible debt, consider these alternatives:

• Convertible debt with a price: Agreeing on a specific price eliminates the cap's risks and prevents the full ratchet from kicking in.
• Series seed equity financing: This type of financing is becoming increasingly popular, offering a streamlined approach to secure early-stage funding without the complications of convertible debt.

Key Takeaways

• Convertible debt with a cap can be a risky choice for founders, often resulting in significant dilution of equity.
• Understand the full ratchet and multiple liquidation preferences, and ensure you have a clear understanding of the terms before signing any convertible debt agreement.
• Consider equity financing as a more transparent and equitable alternative to convertible debt, offering better protection for founders.