How smart investors perceive valuation caps
By: Collin Gutman
Tags: Lessons, Tech, Startup, Venture Capital

Most VCs have looked at deals before. Maybe they’ve done it while working at another fund, maybe they’ve done deals as an angel, etc. Generally speaking, when you’re meeting with a VC that has successfully raised a fund, you should assume they’ve only raised that fund because they have a background that makes them a reasonably legitimate investor. Some may be better than others, but surely a VC that has been trusted with millions of other peoples’ money understands a convertible note.

I’m therefore constantly surprised by how many entrepreneurs feel compelled to explain that my comment that the cap on their note is too high isn’t valid because “well it’s just a cap, it’s not a valuation. We’re not setting a valuation — you idiot” (OK, that last part may just be implied, not overtly said… most of the time). And yes, I understand what a valuation cap means. The entrepreneur just doesn’t see the cap the same way I see the cap (or doesn’t want to). So I figured it makes sense to explain how VCs think of caps.

We assume that we’re paying the valuation cap. So if the cap is too high, the valuation is too high. Here’s why:

If things go great, which is what we’re hoping for, we’re paying the cap. If all goes according to the plan we all believe in, our capital will help you grow the business and you’ll raise at or beyond the cap. So always rooting for the best, we assume we’ll pay the cap. If we’re not paying the cap because things don’t go well by your next round, we’re in trouble. Venture is a game of winners and losers. Very few startups raise venture capital, do “OK” then have a “decent” exit. Generally you’re scrapping to get investors’ money back, or you’re a rocket ship. There are a bunch of reasons for this — multiples based on growth rates — but just assume that’s directionally correct for now. So if you’re not the rocket ship and we’re not paying the cap, our investment didn’t work. So if paying less than the cap seems like a likely outcome, this is probably not an investment we should be making. Even if the most optimistic case has your valuation being far lower than the cap, there are still ways we end up getting screwed and paying the cap. Some investors will say “well our cap is $30M, but even if we hit revenue goals we’re likely to raise $5M on $25M next year.” That may be true, and that may be the plan for today, but nobody knows what the future holds. A great (or terrible) investor could come in and offer a much larger amount of capital on a much larger valuation than expected. Or the company could pursue venture debt and growth solidly for an extra 12 months before raising the next round. Both of these are (generally) great for the business, and should be great for investors. But if the cap gets set artificially high, there’s a misalignment of interests, and even a well-intentioned CEO can force his investors to pay up.

Small bridge notes (meant to last 3 months, generally raised from insiders) may be different from this. But generally speaking, if you’re raising a true investment round meant to last the company 9+ months, don’t assume that a VC doesn’t understand a valuation cap if they push back on it. Assume it means they understand the scenario and just don’t believe the valuation to be fair. Then you can figure out whether to amend the cap or tell the investor you’ll find others willing to pay your price. But at least make your decision assuming the investor understands the scenario and believes a negotiation is in order, not that they need an explanation on convertible notes. Just assume VCs will see your cap as your valuation — then you can have a substantive discussion about whether the valuation is “right.”