(I'm a VC)

Uncapped notes are generally a bad idea for everyone involved because they misalign incentives. If you raise a seed at a $6m cap, both your goal and your investors' goal is to help you make as much progress as possible for a Series A. For instance, investors will do whatever they can to help you get to a $30m valuation instead of a $20m valuation. An uncapped note means that investors invest at your next round's price. That means they benefit most of the price of your next round is low. I.e. they'll do as little as possible so that your Series A is at a $20m pre instead of a $30m pre. The misalignment creates perverse incentives. For example, if you ask an investor on an uncapped note to make a key customer intro, if they say yes then their reward if you land the customer is that they'll have even less ownership at the Series A. That's not a good incentive structure :)

If an investor would rather own 5% of a $20m company than 3.3% of a $30m company, and specifically limits a company's growth to achieve that end, then it's likely someone no founder would want to work with. Make the pie bigger, no?

The real problem with capped notes is that they serve as a proxy for price. If you're going to price it, just price it. But if a note had a floor + cap that served as a min/max range for what everyone felt comfortable with, and then utilize a discount to do the actual work of allowing for uncertainty in the valuation, that would be the setup that best encapsulates the spirit of convertible notes (of course, the devil is always in the details).

> If an investor would rather own 5% of a $20m company than 3.3% of a $30m company

It's not that simple because you're not factoring for time. Yes, both of those stakes are worth $1m, but the risk levels taken by an investor are different. For example, would you rather own 5% of Amazon when it was worth $20m, or 0.01% when it's worth $10b? Those are both $1m stakes if you ignore time, but the latter would've been worth much less than the former.

Here's a concrete example using https://angelcalc.com/model

Priced round

I invest $1m at a $10m post, owning 10%.

- If your next round is $5m at $20m pre, I'll own 8% (post-dilution) which will be worth $2m.

- If your next round is $10m at $40m pre, I'll own 8% which will be worth $4m.

If your valuation doubles, so does the value of my investment, and I keep an 8% take in either case.

Uncapped note

I invest $1m on an uncapped note, 20% discount.

- If your next round is $5m at a $20m pre, I own $1.25m (5%).

- If your next round is $10m at a $40m pre, I own $1.25m (2.5%).

Note that 1) my upside is capped to $1.25m (that's the 20% discount I got) and 2) the better your next round, the lower my ownership.

Closing thoughts

The reason the uncapped note is even more unattractive is that most companies have some perceived ideal outcome. Let's say it's a max $2b exit for this specific company. For a priced round, I own 8% of a company that could go up to $2b in value. For an uncapped note, I own 5% if you raise at a $20m pre, or 2.5% if you raise at a $40m pre. Note that the better you do, the lower my percentage, and hence the lower my potential upside. If you raise at a $20m pre my stake might be worth $2b x 5% = $100m someday. If you raise at $40m pre my stake might be worth $2b x 2.5% = $50m someday. If you really knock it out of the ball park and raise $20m on an $80m pre for your Series A, my max upside is $25m. Again, this makes no sense because I invested $1m at the exact same time in both the priced round and the uncapped note round, but in the priced round instance I own 8%, while in the uncapped round I probably own much less, and the better you do on your way to a $2b exit, the worse I do. That's a strong misalignment and there's no way for me to make that pie bigger.

I said this in another comment but it seems like these cases are assuming a long time passing between the SAFE and the priced round. Not sure if DelaneyM and pmcaffey are referring to that.

If SAFE is a way to start what would be a priced round (a few months), then your numbers would tell a different story. You getting to invest $1M and $10M cap, and then the company raising at $20M valuation later, means that you got an unfairly low priced deal (assuming company's valuation wouldn't naturally double in those couple of months).

In short timeframes (SAFE -> Priced rounds), its hard to imagine something other than discounts being fairer to all parties concerned.

In longer timeframes where the next priced round is a Series A, an year later, your point stands and is well taken.

Thanks Leo for the detail response. The problem with this analysis is that you're comparing a priced round to an uncapped note, but using totally different and arbitrary parameters (ie. 20% discount).

I agree 20% discount is not an accurate assessment of the risk and potential increase in value from seed to A, which is usually 3x. Also, the original purpose of a note is to solve the problem of inaccurately pricing an early stage company. If that's not a problem then there's no point in not pricing. But if there's great variation in the potential of a company, then it makes sense to use a variable pricing model, which a significant discount (30-60%) better accounts for. Add in a cap and a floor (something like $4m - $40m) to protect founder & investor in extreme situations like you described.

Obviously a fixed price is better for you, the investor. But is it better for the company? Is it the best way to model the uncertainty of valuation? You argue for not dissentivizing the investor. What about the founder who raises $1m seed at $5m valuation, then raises Series A at $30m? They mispriced their seed round, and the likelihood of the A investors finding a way to diminish the value of the seed investors greatly increases.

Just an alternative view of things from an outside.

I appreciate the follow up. I think where we disagree is that a priced round is a disincentive to the founder. Instead of a disincentive, I think a priced round is "fair." A few quick comments:

- are there any other areas where, as a buyer/investor, you buy at a discount to a future price instead of an estimated current price? For example in places where houses appreciate quickly, people still buy houses at a fixed price. No seller ever says "this house might be worth $2m-5m in 10 years, so instead of buying it for $1m today, which don't you buy it for a 20% discount to when you sell it 10 years from now?" Same thing with paintings, stocks, etc.

- the $5m -> $30m mark-up is not a mispricing. For public stocks, pricing is based is based on expected cash flows. For example, if a company is expected to make $10m/year for 30 years, it might be worth $300m today, minus an adjustment for inflation (so maybe it's only worth $200m today). For startups, the valuation is based on "% chance of a huge outcome." So when a company goes from $5m to $30m in valuation, that doesn't mean its revenues jumped 6x. What it really means is investors think the company made enough progress so that instead of a 1% chance at a $1b exit, there's now a 6% chance at a $1b exit. In that regard, the company is worth $30m today, but it was also not worth that at the seed round.

There is no way to know at the beginning if you'll be a $0M or $30M company and to make their portfolio math work they need as much upside as possible if you get to a higher valuation. The pie is fixed at 100% and everyone is fighting for more of it.

The real problem with capped notes isn't the proxy for price, it's that the cap table is impossible to discern. Capped notes actually do have an advantage in that you can do a rolling close of your round, so you don't have to have everyone invest at the same time on the same day. The downside is that it is hard to explain to your employees exactly how much they own since it depends on how the notes convert.

can't price it without it being a real equity round in which case closing costs are the real issue (the other reason why converts work well at early stages)

How about splitting the difference? One could issue a note that prices at the geometric mean of an agreed-on number (what would have been the "cap", but it's obviously not a cap anymore) and the Series A valuation. So if the agreed number is $6M and the round is priced at $20M, the note would convert at sqrt(6 * 20)M = $10.95M, but if the round prices at $30M, the note would convert at $13.41M. Seems like this would still leave the investor with plenty of incentive to help the business grow, without giving them what can seem an outsized share of that growth.

1) I think that's an interesting idea.

2) Complex pricing is hard to implement well (both for valuations and for product prices). It's friction for what could be a straightforward transaction.

3) It's not clear to me why the investor would want their upside capped. E.g. if I buy stock in your company and the company becomes more 3x more valuable, then why would I be okay with my stock being 2x more valuable? Why not 3x just like you? (And likewise, the founder wouldn't want my stock to be 4x more valuable if the company is 3x more valuable).

Just throwing out an idea. I think I'll have to play with the dilution calculator for a while before I even form an opinion as to whether there's a good answer to your question. I was just going off the observation that uncapped notes are apparently not completely unheard of, for whatever reason, and so maybe there's some room for compromise.

Does your assessment change at all if your horizon extends beyond the next round?

Not really. If a fair price for your company is $10m today or $40m in a year if you do well, there isn't a good reason to invest at $40m today (or even a discount like 20% off $40m).

An analogy: Amazon is $1k/share today. Let's say you think there's a 30% chance it will 3x in the next year. Would you like to invest at $2.5k/share today? The answer is No because that has negative expected value, and you'd rather just wait a year and invest at $3k/share than investing at a small discount to $3k/share today when the stock is worth much less than that.

Also, the time horizon doesn't change the misaligned incentives here. Because I get in at next round's price, I would prefer for that price to be lower.

It seems like a hidden element that we aren't talking about which really might affect everyone's reference points is the time duration between SAFE and priced rounds.

For a lot of people, I see the difference being the start of the process, and the end of process which can be a few months - in which case, an uncapped with discount seems entirely reasonable.

It seems like you are referring to a case where a substantial time has passed to materially affect the valuation in a substantive way?

Isn't the whole point of notes to address the uncertainty of valuation? In your example, what happens when there's no 'fair price today'? If you think there's a 30% chance Amazon will be worth 3k in a year, what price would you pay now?

Usually fair price is based on some combination of 1) market price and 2) the investment's expected value, adjusted by some return hurdle rate. For example, if I'm looking for a 25% annual return, and next year I think Amazon is 70% likely to be $1000/share and 30% likely to be $3000/share (weighted avg = $1600/share), then a fair price might be $1280.

the point of notes is to be able to raise without expensive legal fees and be reasonable on valuation (i've done a lot of angel investing and when i invest i want a "starting point" - doesn't have to be crazy low but has to "make sense" - at least to me; 20% discount on next round isn't appealing enough {why would an angel putting money super early with the greatest chance of losing it all only get a relatively small discount})

Ease and simplicity is definitely the biggest reason notes have continued to be used. But their original purpose was to solve the problem of setting a price on early stage companies.

I agree that 20% discount by itself is not appealing enough incentive for the risk of early stage investment. But what about 40%? ...50%? A discount is just the mechanism that most accurately captures the variable nature of valuation. Finding the right number is where the modeling happens.

I believe 25% is the smallest discount I've seen thrown around, 40%-50% is rather common.

As was mentioned elsewhere, smaller discounts tend to apply to shorter horizons, such as when bridging immediately into a round. In those cases, they can be a good way for VCs to get on the cap table with prorata rights without having to muck around in series-A drama.

I'm unclear on how the cap would be a starting point? To DelaneyM & pcmaffey's point, it then becomes a proxy for price, so you've effectively set a valuation.

Would it be more appealing if you the round was closed in the next few months, so you investing early would be well rewarded with the discount?

No investor will do an uncapped note (unless it's a bridge round) because it's a very bad deal for them. A fixed discount on the round is not enough upside to account for their risk, especially when there are plenty of investments available whether they can get a cap which gives them much more upside.

Investors will do uncapped notes for bridges because there is usually a very short time period between the note and the next round, so they actually make a better return due to the discount than they would in equity appreciation over that short time.

> Having a cap is an incentive for me to "grow until I'm 6 months away from X, then focus on raising instead".

This was my impression as well. I do understand that the deal has to be equitable for both sides. It also has to align interests and as your example shows, the cap doesn't.

The discount obviously makes sense since the seed funder is taking more risk.

This makes a lot of sense, and is also my preferred route. Have you had any feedback or pushback on this route yet?

I am also curious how the reactions differ from Angels to MicroVCs to Seed Funds.

So far everyone's been happy with an MFN, so it hasn't been much of an issue. (They seem happy to let someone else be "the bad guy" who forces terms.)

If I secure enough commitment on MFN agreements alone, I plan to default them all into a fairly generous discount.