Convertible Note: Cap

By Spartina     Add your comments

Questions to consider for the Cap in a Convertible Note:

Convertible Note Continued:

What other protection will you offer your Investors?

Sophisticated angels might ask you to put a cap on the valuation that their investment dollars will ultimately convert into, such as $2 million pre-money. If the next equity investment occurs at a higher valuation than the cap, then the conversion is performed as if the valuation were at the cap value. In other words, to calculate the number of shares for the conversion, you would divide the loan amount by the lesser of either discounted next equity financing price, or, the price based on the cap.

Tip:  To put the cap into effect, you also like to keep the liquidation preference on a par with the new investors. Thus your Convertible Note investor will get his shares in two batches, some as preferred, and an additional set of shares of common stock. This is carried out by a complicated formula whereby the original cash investment (note) is divided by the per-share price of the next round to come up with the number of preferred shares. An additional calculation is made based on the valuation cap to come up with the total number of shares the investor is entitled to. The difference between the number of preferred shares, and the total number of shares is issued as common stock thereby keeping the liquidation preference on par with the new investors.

Example: $100,000K Note. Cap valuation is at $.50 a share. Series A is at $1.00.
The note holder is technically entitled to 200,000 shares ($100,000 / .50). However, with the liquidation preference at $1/share, then he would be entitled to 100,000 ($100,000/$1.00 = 100,000). So 100,000 shares are issued as preferred and 100,000 shares are issued as common.

Tip: Use a lawyer. This is where the lawyers earn their fees!

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