Uncapped Convertible: What is it and how does it benefit founders?
Since we announced Accel Atoms, our pre-seed funding and mentorship program, we have received multiple questions from founders on how an uncapped convertible works.
Here's a primer for everyone who wants to get up to speed on this founder-friendly funding instrument!
Early-stage startup funding typically happens in one of two ways:
The first is called a ‘priced round’, where you raise money from an investor after mutually aligning on the company valuation. The investor writes you a cheque in return for a percentage equity in the company.
The other is through what’s commonly known as a ‘convertible’ where you get the dollars from the investor, but don’t immediately give away any equity. Instead, you build your business, and part with equity when you’re raising your next round of funding. The amount of equity you give away is based on the valuation during this new funding round.
Consider the following:
Say you (and your co-founder) need capital to experiment with an idea. You are convinced that this has the potential to turn into something big, but it’s too early to put a number or valuation to it. A convertible is ideal in this situation. Since you don’t need to give the investor any percentage equity, you don’t need to figure out a valuation. You can simply take the money and focus on building your business.
For example, say an investor (A) agrees to give you a convertible of INR 1 Cr as seed funding. You use that capital to build out your product , and are ready for the next round in a few months. In the second round, a new investor (B) agrees to give you INR 5 crore, in exchange for a 10% stake. This values your company at INR 50 crore.
At this point, investor A gets equity in exchange for the INR 1 Cr they had initially invested. So in this example, they will get 2.2% equity (INR 1 Cr on a pre-money valuation of INR 45 Cr)
In this process, not only did you avoid worrying about the valuation at an early, formative stage of your business, you also avoided giving out too much equity too early. There is more nuance to the process, but these are essentially the benefits of taking this route. You can check out a simple comparison of priced and convertible scenarios here.
Now that you’ve understood how convertibles work and why they might be better choice for you, here are ways in which we have made Atoms more founder friendly:
- In certain cases where investors want a minimum assured percentage of equity from their convertible, they put an upper limit on the valuation at which their initial investment will convert to equity. This is called a ‘capped’ convertible. In the example above, if the convertible had a cap of INR 20 Cr, then even though the company raised the next round at INR 45Cr pre-money valuation, investor A will get shares based on an INR 20 Cr valuation (5% equity instead of 2.2%).
- In certain cases where investors want an additional benefit compared to other investors who are coming later, they put in a discount criteria on the valuation at which their initial investment will convert to equity. This is called a ‘discount’ rate. In the example above, if the convertible had a discount rate of 25%, then even though the company raised the next round at INR 45Cr pre-money valuation, investor A will get shares based on an INR 33.75 Cr valuation (3% equity instead of 2.2%).
No valuation limit or discounts
At Accel Atoms, we have no valuation limit or discounts. We offer an ‘uncapped’ convertible and support our early stage founders in sharing equity at fair market valuation.
- In certain cases where founders aren’t able to raise larger capital in future rounds, convertibles can cause higher dilutions for founders (corner case). To safeguard founders against it, we will automatically convert our convertible into percentage equity only if the next funding round is more than $5M in funding amount. In cases where the company raises a lesser amount in the next round, we will discuss it with the company on what would be the best option for them.
If you’re an early stage founder and passionate about what you’re building, we’d love to talk to you! You can apply for Accel Atoms here.
