Capped Notes: The One Term Sheet Detail That Can Make or Break Your Investment
Unlock the secrets of capped notes—how they impact valuations, dilution, and investor returns in early-stage funding.
Dear Readers,
Welcome to the latest edition of the HealthVC newsletter. As a managing partner in a venture fund, I’ve seen my fair share of early-stage deals where capped notes played a crucial role in shaping both investor returns and founder dilution. If you’re a founder raising capital or an investor evaluating a startup, understanding the nuances of capped notes isn’t optional—it’s essential. Over the years, I’ve navigated countless negotiations on valuation caps, investor protections, and founder equity, and I can tell you firsthand that the way a capped note is structured can make or break an early-stage investment.
Let’s dive into why these instruments matter and how to use them wisely.
What Is a Capped Note?
A capped note is a convertible debt instrument that allows startups to raise money without immediately determining a valuation. Instead of setting an exact price for equity today, investors provide capital in exchange for a future equity conversion—usually at a discount or at a valuation that does not exceed a pre-agreed cap. This cap is a crucial safeguard for investors, ensuring they don’t get squeezed out when the startup's valuation soars in a later funding round.
In simpler terms: If I invest in a startup at an early stage, I want to make sure that when the company raises its next round at a much higher valuation, my investment converts at a reasonable price. The cap gives me that assurance.
Why Capped Notes Matter for Investors and Founders
1. Investor Protection and Fair Upside
I’ve been in deals where early investors got crushed in later rounds because they lacked downside protection. A cap ensures that we, as investors, are rewarded proportionately for the risk we take when betting on a company in its infancy.
Imagine I invest in a startup with a valuation cap of $10M, but by the time they raise a Series A, the valuation has jumped to $50M. Because of the cap, my investment converts as if the company were worth $10M—not $50M. Without that protection, my early capital would be worth a fraction of what it should be.
2. Founders Need to Balance Dilution vs. Attracting Capital
For founders, caps are a double-edged sword. Set them too low, and you risk excessive dilution. Set them too high, and investors might not bite. I’ve had conversations with founders who wanted to set their cap at sky-high levels, thinking it protected them, only to find that investors walked away. The right balance depends on market conditions, your startup’s traction, and the strategic value of your early backers.
3. The Discount Rate Adds Another Layer
Capped notes often include a discount rate—usually 10-30%—that allows investors to convert their investment into equity at a reduced price compared to new investors in the next round. This means that investors typically receive a better deal between the cap and the discount. In some cases, the discount matters more than the cap; in others, the cap is the dominant factor. The key is structuring it in a way that aligns incentives.
How to Set the Right Valuation Cap: A Venture Fund’s View
Having structured and negotiated numerous capped notes, I’ve seen the factors that influence the right valuation cap. Here’s what I consider:
1. Market and Industry Trends
Competitor Benchmarking: If companies in your space are raising at certain valuations, that’s your benchmark. No investor will ignore comparable deals.
Investor Sentiment: In hot markets, founders have more leverage. In down markets, investors call the shots. I’ve seen cycles where caps fluctuate dramatically based on investor risk appetite.
2. Company-Specific Metrics
Growth Trajectory: If a startup is growing at an exponential rate, I’m more open to a higher cap. If growth is uncertain, I want more downside protection.
Revenue and Profitability: If a company has real revenue and a path to profitability, I’ll entertain a higher cap. If it’s pre-revenue, I need a strong reason to take the risk.
Strategic Assets: A proprietary technology, a strong patent portfolio, or high-profile partnerships can justify a higher cap, but only if they offer a clear competitive advantage.
3. Founder-Investor Relationship and Negotiation Power
Risk Appetite: Some founders prefer to take a lower cap to secure strong investors, while others push for a higher cap and risk losing potential backers.
Investor Reputation and Value-Add: I’ve personally given founders better terms because I knew I could bring more than just money—connections, industry expertise, and operational support.
Future Fundraising Plans: If multiple rounds are expected, early investors will push for a lower cap to avoid excessive dilution later.
4. Broader Economic and Regulatory Considerations
Macroeconomic Climate: In uncertain times, investors seek more protection. I’ve had founders come to me in bear markets expecting high caps, only to be surprised when investors pushed back hard.
Regulatory Factors: Changing tax laws, securities regulations, or geopolitical events can shift the attractiveness of certain deals, influencing valuation caps as well.
Pitfalls and Alternatives to Capped Notes
While capped notes are powerful tools, they aren’t perfect. I’ve seen founders regret taking on too much dilution, and I’ve seen investors get squeezed out when caps were set too aggressively. There are alternatives worth considering:
1. Uncapped Notes—High Risk, High Reward for Founders
Some startups offer uncapped convertible notes, where there’s only a discount rate but no valuation cap. This is great for founders but a tough sell for investors. I rarely invest in these unless there’s a strong strategic reason.
2. SAFE Notes vs. Convertible Notes
The Simple Agreement for Future Equity (SAFE) is another option, especially in Silicon Valley. Unlike convertible notes, SAFEs don’t have interest rates or maturity dates. I’ve invested using both, and while SAFEs can be founder-friendly, they lack some of the investor protections that convertible notes provide.
Final Thoughts: Capped Notes as a Tool, Not a One-Size-Fits-All Solution
Capped notes are a crucial tool in venture investing, but they need to be structured thoughtfully. The best deals strike a balance between rewarding early investors for their risk and ensuring founders don’t give away too much equity too soon.
From my perspective, if you’re a founder raising on a capped note, think carefully about what the cap says about your business. If you’re an investor, make sure you’re not just throwing money in without ensuring fair upside protection.
At the end of the day, early-stage investing is about alignment. The best deals are those where both sides feel like they got a fair shake.
Have you structured or negotiated capped notes before? What challenges have you faced? Let’s discuss this—I’d love to hear your thoughts.
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