Understanding convertible securities: Valuation cap and discount

What is a Convertible Security and Common Types of Investment Convertible Securities

A convertible security is an investment that can be changed from its initial form into another form of security. Two of the most common forms of investment convertible securities are convertible promissory notes and simple agreements for future equity (i.e., SAFEs), which allow investors to safeguard their investments into companies with the promise of repayment or conversion into equity of the target company upon the occurrence of certain events.

• Convertible Promissory Note: A convertible promissory note is a promissory note that can be converted into equity. Convertible promissory notes are debt and typically include a fixed maturity date, interest, a right to enforce payment, and similar terms.


• SAFE: A SAFE is a contractual investment that allows the investor to receive shares of the target company at the initial closing of a future financing or to receive repayment of the original purchase price upon a change of control of the target company, a dissolution of the target company, or any other similar events. A SAFE is not considered debt and therefore does not generally include an interest rate, maturity date, or other terms (e.g., security interests, seniority, etc.) that would typically appear in a debt security.

Regardless of whether a company issues a convertible promissory note or a SAFE, a common question from founders, chief executive officers, and investors is, “should we set a valuation cap and/or a discount?”

Valuation Cap and Discounts

Generally, the benefit of investing in a convertible promissory note or a SAFE is that such instrument will convert into the equity being sold (typically preferred stock) in the next equity financing at a lower price per share than the same security sold to cash investors in that same equity financing. Valuation caps and discounts are methods to give the holder of a convertible promissory note or a SAFE a benefit at the time of conversion by giving them more shares than if they had waited to invest directly into the equity financing.

Generally, a convertible promissory note or SAFE will convert into a number of shares equal to (i) the outstanding principal amount (and possibly accrued interest in the case of a promissory note) by (ii) a conversion price. The applicable conversion price depends on the discount and/or valuation cap.

• Discount: A discount takes a percentage off the price per share of the next equity financing. For example, if a SAFE has a 20% discount and cash investors are paying $1 per share, the conversion price of the SAFE will be $0.80.


• Valuation Cap: A valuation cap sets a valuation at which the instrument converts into by dividing the valuation cap by the company capitalization at the time of conversion. For example, if a SAFE has a valuation cap of $10,000,000 and the target company’s capitalization is 1,000,000 shares (or common stock equivalent), the conversion price of the SAFE will be $10.

However, the terms of the discount and valuation cap can be negotiated.

Discounts

When negotiating a convertible promissory note or SAFE with a discount, the main conversion related term to be negotiated will be the applicable discount. Discounts can typically range from 5-30%, and it depends on the stage of the company, the extent of the risk of the investment, whether the funding is from a new investor or existing investor, the length of time before an anticipated equity financing and what leverage the Company may have.

Further, discounts need not be a straight percentage but can be bifurcated. For example, for the first six months, if a conversion is triggered, the discount is 10%, but if conversion does not occur until after the initial six months, the discount can increase to 15%. This allows the parties to split the risk of dilution – meaning that (i) if the investment converts within a relatively short period (which suggests that the investment was less risky), the discount is lower and the existing stockholders of the company suffer less dilution, and (ii) if there is a longer period before the conversion of the investment (which suggests that the investment was riskier), the discount is higher and the existing stockholders of the company suffer more dilution.

Valuation Cap

When negotiating a convertible promissory note or SAFE with a valuation cap, the parties need to negotiate the valuation cap and what will be included in the company’s capitalization which can affect the calculation.

• Valuation Cap: Because a valuation cap will always be company specific, there is no standard range. Investors will push for a lower amount while the Company will argue for a higher amount because the lower the price per share that results from the calculation, the more shares that an investor will receive upon conversion.


• Company Capitalization: There are generally two approaches to defining the company’s capitalization: pre-money capitalization and post-money capitalization.


• A pre-money capitalization will typically include all capital stock outstanding as of the date of the equity financing, such as all outstanding options, warrants and other convertible securities and all shares of stock reserved under any equity incentive plan. This would not include any outstanding convertible promissory note or SAFE. Therefore, the valuation cap represents the value of the company immediately prior to the conversion of the convertible promissory note or SAFE. A valuation cap that uses a pre-money capitalization is referred to as a “Pre-Money Valuation Cap”.


• A post-money capitalization will typically include all capital stock outstanding, all outstanding options, warrants and other convertible securities and all shares of stock reserved under any equity incentive plan, plus any convertible promissory note or SAFE outstanding. Therefore, the valuation cap represents the value of the company immediately following the conversion of the convertible promissory note or SAFE. A valuation cap using a post-money capitalization is referred to as a “Post-Money Valuation Cap”.
  
  Whether representing an investor or a company, it is important to focus on the reserved option pool because whether to include an option pool increase in either a Pre-Money Valuation Cap or a Post-Money Valuation Cap is a negotiated point. Further, the current Y-Combinator form of SAFE strikes a middle group that an increase to the option pool is only included in the definition of company capitalization if those shares have already been promised. This term benefits companies.

While valuation caps are not a “valuation” of the Company, many investors and companies tend to look at the valuation cap amount as a proxy for valuation.

Configurations of Valuation Caps and Discounts

A valuation cap and discount are not mutually independent but can be used together. There are generally four variations of using of a valuation cap and discount:

• Valuation Cap and Discount: In many instances, companies may give investors the benefit of a discount and a valuation cap so that the investor will receive whichever calculation will yield more shares in the next equity financing.


• Valuation Cap Only: When a company provides the holder of a convertible promissory note or SAFE with the benefit of a valuation cap, generally the holder is entitled to convert the instrument at the lower of (i) the price determined by the valuation cap and (ii) the amount paid for the equity by cash investors in the equity financing. In this way, if the equity financing values the company lower than the valuation cap, the holder of the convertible promissory note or SAFE is not adversely affected.


• Discount Only: When a company provides the holder of a convertible promissory note or SAFE with the benefit of a discount, there is no need to provide an alternative calculation because the holder will always convert at an amount less than the cash investors in the equity financing.


• Neither Valuation Cap nor Discount: In rare instances, the company may push for the holder of the convertible promissory note or SAFE to convert at the price paid by cash investors in the equity financing. This option is generally limited to companies needing funding reasonably close to the closing of an equity financing and is effectively a pre-funding of the investors' investment at the initial closing of such equity financing.

Please note that many variations exist with respect to discounts and valuation caps, and there are many relevant design considerations.

A DLA Piper team member can assist you with any questions you may have.