Why high convertible debt valuation caps harm both investors and entrepreneurs

As a seed stage investor, Romulus Capital looks to invest in very young companies. We’ve backed startups as early as when they’re simply a passionate founder with an innovative idea, as in the case of E la Carte. The startups that had shown the greatest progress by the time we funded them were those with a working product, as was the case with Crocodoc. While the latter batch of startups may have customers, they are most likely not a meaningful source of revenue at the time of our investment. This is because our startups often choose to make their product available free of charge in order to gain traction. As a result, almost all of the companies we fund have no revenue at the time of investment. 

The majority of our investments are in the form of convertible debt with a valuation cap. This is the most commonly used investment instrument for seed stage funding in the US. Like other investment instruments it has its advantages and disadvantages, but these are the topic of a later post. What I’m going to focus on today is the very high valuation caps which we’re seeing for the pre-revenue startups that we’re looking to fund in the US.

At its core, the valuation cap on a convertible note serves to compensate seed stage investors for the large risks that they’re taking by investing in companies at the earliest stage. It is used to determine the maximum valuation at which the note converts into equity at the first equity funding round. For example, if a startup were to receive a $10M valuation in its first equity round, a $2.5M cap would ensure that the note converts into equity as if the startup had been valued at $2.5M. This would basically give seed stage investors a 4X return on their initial investment. While this may seem high at first, keep in mind that the majority of seed investments are written off. As a result seed investors need returns similar to 4X between funding rounds to hit the home runs necessary for their portfolio to generate a meaningful positive return.

The problem arises when the valuation caps are so high that seed stage investors are not properly compensated for the risk of their investment. As an example, consider that the caps of the three most promising deals that we’ve recently looked into are $5M, $6M, and $10M. In other words, if the startup shows sufficient progress to raise an equity round, the note will convert into equity at a valuation between $5M and $10M depending on the startup. Applying a very aggressive 10X revenue multiple to this valuation implies that the company should currently be earning, or be fairly assured of earning, between $500K and $1M in annual revenue to deserve such a cap. This is inconsistent with the fact that the startups which we back are almost always pre-revenue.

The mismatch between the valuation caps which seed stage startups in the US are currently being offered and what their fundamentals deserve has a negative impact which extends beyond investors to the startups themselves. The negative impact for investors is clear. Knowledgeable investors find themselves unable to participate in the funding of promising startups because the terms simply don’t make financial sense. Since knowledgeable investors abstain from investing, funding rounds are primarily filled with those investors who have little ability or willingness to add value to the startup. This is a disadvantage for startups at all stages, but a particularly important problem for seed stage startups who can benefit greatly from the domain expertise and network of connections brought by the right investor.