This article first appeared on TechCrunch.com

The convertible note is a useful and common financing structure in Silicon Valley. It’s a form of debt that is really more a type of equity — one where the valuation hasn’t been determined yet.

It’s helpful because sometimes you want to align a new investor or bridge a company with extra capital, but not argue about the valuation or have to price the round yet. Many bureaucratic institutions, for example, would make you do all sorts of studies to justify any particular valuation — and you are busy building your business. You want the investor aligned (or want their cash, at least), but prefer to price the round a little down the road.

So the investor loans money to the company at some low rate of interest (usually 3–10 percent) and has all the senior protections of a debt-holder if anything should go wrong. When the next institutional round of capital is raised — usually defined by an investor coming in with at least several million dollars in a priced round — the note and interest converts into that round at some pre-determined discount to its price (usually 10–20 percent). The note holder becomes an equity holder with shares that have the same rights as those in the new round, at a slightly better price.

At a high level, there are two types of notes: capped and uncapped. You should (almost) never raise a round on an uncapped note, as it pits the incentives of the investor and the company at odds with each other.

We use convertible notes a lot at our fund, 8VC — so often that we just call them “notes” to save time. Capped notes are a great alternative to a priced seed round, and a great way to align relevant people in your community or business vertical in between your A, B, C or D rounds. They’re also sometimes a life-saver (or at least a cap-table saver) for companies who use them as a financial bridge to get their ducks in a row and give themselves a few (or more) extra months to hit an inflection point before pricing their next big round.

Of course, companies will generally pretend they are doing the alignment thing rather than admit they needed a few extra months of runway. (Don’t tell anyone, but “We are looking for some strategic partners who can give us advice before we do our next round, and are using this convertible note to align them financially,” is often Silicon Valley speak for, “We need some extra cash so we have the runway to show some better progress before we try to raise a big round.”)

A capped note means there is a maximum valuation at which the note will convert. A typical cap on a seed round note is $10 million. This is fair, as is $5, $8 or $20, incidentally, depending on the group and what they are doing. What’s ridiculous is an uncapped seed round. If the company doesn’t get strong early traction, the investment might be worth nothing, yet many of us have also heard of a company like this taking off and stories of the first priced round being raised at $100-pre. Instead of getting 10 percent or 5 percent for your first $500,000 if you’re an investor, you might now be getting less than 0.5 percent of the company.

Of course, there’s nothing unethical about this — it just means you were bad at structuring your investment. You should have insisted on a cap, or else a priced round. Usually, a good entrepreneur wouldn’t have done this to you — it’s not how almost any of the top people in our ecosystem treat others, as the true talent knows this is a repeated game and that honor and reputation is worth more than whatever percentage points they can get from chicanery.

But the thing that makes uncapped notes especially bad is that the incentive of the investor and the entrepreneur should always be aligned.

It’s wrong to put an investor in a situation where they are deciding between helping their ownership stake versus helping the entrepreneur.

When we invest in a company at 8VC, it’s our job to make that company as successful as possible — from an internal product and strategy perspective, but also in terms of who it is able to hire, what its customers think about its product and its mission, what the media says (but not until that matters) and what other investors think about it. The goal is to help the entrepreneur put their best foot forward in the way that’s the most positive and true to the company and its mission.

Entrepreneurship is in large part about building something from nothing, which means creating a cause. And causes are not created in isolation — great investors are fully aligned with their entrepreneurs and do what they can to push forward the cause along with their most relevant touch points in the community at any given time. Backing a company is a serious business.

Now go back to our $500,000 investor in that uncapped seed round. As he sees the company take off, what are his incentives? At some point, it’s not clear. Maybe he realizes these are amazingly talented entrepreneurs who are on to something, but he secretly hopes a couple of the early attempts will stumble so that they’ll have to raise money at a lower valuation than what they’d get otherwise, so he can convert in.

What does he say to the star designer who is interested and who he knows by joining might drive their valuation even higher before his note converts? And maybe he looks down and mumbles instead of playing them up to a top investor who is excited to invest at a really high valuation, in order that he gets in at a lower price. Or maybe he doesn’t, because he’s honest to his principles and he wants to be aligned with the entrepreneur even against his own interests.

With an uncapped note, you are often creating an incentive for an investor to hope you do well enough that you are going to win in the future, but maybe have some struggles and raise at a relatively low valuation next time.

In our view, a great investor should never have to face that conundrum. It’s wrong to put an investor in a situation where they are deciding between helping their ownership stake versus helping the entrepreneur. I’d like to think I’d always side with the entrepreneur in this situation — it’s who we are and it’s our mission at 8VC — but I’m also driven to win for my LPs who are betting on me: I know my partners and I feel strongly about being good players and role models in the ecosystem, but we are also fiercely competitive to do as well as possible for our IRR.

“Power corrupts” wasn’t just written about madmen who take over governments; it’s true for all of us, and it happens in small ways. Incentives and spheres of influence are powerful things, so it’s critical we keep them as aligned as possible.

There is one scenario wherein it can make sense to do an uncapped note, but even then the note should never be truly uncapped. This scenario is the insider-led bridge round, where the note is expected to be short-lived. If an investor already has equity in a company, she is aligned to make the company’s valuation go up, but she might want to bridge the company; that is, give it the money it needs to keep operating until it completes its next raise.

If the next round is imminent (within the next month or so), the cap on the note can interfere with a pricing discussion. In this case, doing something that ladders is right. For example, you could offer a note with terms of no cap if the round is done within two months, but with a cap and a discount if the round is done within four months, a bigger discount at six months and so on and so forth.

In general, the best solution is to place the cap at a valuation in which you are very confident you can hit that is likely below your next round. Contrary to popular belief, a cap is not always a signal for the price of the next round. It’s true that many rounds are raised near their caps, but I’ve had a note capped at $10 million to let helpful friends into my company that raised its next round at $45-pre, and I’ve seen many great entrepreneurs who value their community take care of allies this way.

In our view, there is a huge misalignment with not having a cap on your notes if your investors have any real influence on your business or the technology and investing community — asking an investor to invest into an uncapped note is about the clearest way possible to tell them they are not connected to any community relevant to your success and don’t matter except for their money. And if they don’t, you should probably find better investors.

Joe Lonsdale
General Partner, 8VC