Navigating Seed Rounds Without Caps: The Pros and Cons

When raising seed funding, startup companies often look towards convertible notes as a flexible and efficient method. However, the decision to use uncappered convertible notes without discounts brings about unique considerations. This article will explore recent examples of startups that received seed funding with convertible notes but without caps, and the implications of such a decision.

Introduction to Uncapped Convertible Notes

The use of convertible notes without caps has been a subject of debate in the startup community. Convertible notes are essentially short-term loans that convert into equity upon the next financing round. Without a cap, the valuation at which these loans convert is determined by the terms of the next round, creating an inherent risk for investors. Many believe that caps and discounts are necessary to protect both the startup and its investors.

My experience with convertible notes without caps from friends and family funding rounds highlights the potential pitfalls and benefits of this approach. Here, we will examine recent examples and the reasoning behind such decisions.

Recent Examples of Uncapped Convertible Notes

One notable example is the seed funding offered by Y Combinator (YC) to its startups. YC provides startups with a $150,000 seed investment in the form of a convertible note with no cap or discount. This no-cap approach is typically beneficial for the startup because it bypasses the valuation negotiations that may not align with the company's fundraising goals. Additionally, the Start Fund, which includes prominent investors like SV Angel, Ron Conway, Yuri Milner, and Andreessen-Horowitz, offers similar terms.

The Challenges of Uncapped Convertible Notes

The lack of a cap can lead to significant disincentives for investors. For instance, if the convertible notes do not have a cap, early investors may have an incentive to encourage later investors to accept a lower valuation. This creates tension within the investor base and may not be ideal for building a strong investor network.

Another crucial point is that without a cap, the conversion price of the convertible notes could be significantly lower than the valuation of the company in the next round. This results in early investors potentially benefiting disproportionately at the expense of later investors. Early investors would benefit from a higher conversion price relative to the valuation in the next round, leading to a lack of alignment between them and the subsequent investors.

Moreover, venture capitalists (VCs) typically avoid investing in companies with valuation caps below the cap set by the new round. Offering a valuation under the cap could damage an investor's reputation and subsequent deal flow. As a result, VCs are often less likely to invest without a cap or may demand a discount to mitigate the risk.

Benefits of Uncapped Convertible Notes

Despite the challenges, startups may choose to use uncappered convertible notes for several reasons. For example, my own startup relied on friends and family funding in the form of multiple small, uncappered notes. Each investment was a fixed amount and not large enough to warrant special terms. This approach allowed us to proceed with fundraising without the complexity of negotiation.

For some startups, the simplicity and flexibility of uncappered notes can be a significant advantage. However, it's crucial to understand the potential implications and be prepared for the possibility of lower post-money valuations and potential conflicts among investors.

In conclusion, while startups can use uncappered convertible notes as a fundraising method, it's essential to be aware of the potential risks and benefits. The examples and experiences shared in this article highlight the need for careful consideration of the term structure and the implications on future fundraising rounds.