complicated concepts

Uncapped Notes

Last week I got pitched on a company that, on paper, is doing great.

Their growth is solid, the founder is presentable, and the company has found product/market fit.

There was just one thing bugging me: the opportunity was to invest on an uncapped note.

"What's an uncapped note?" I asked. "And is it a good thing or a bad thing?"

Now, my research and conversations quickly showed me that this is a big hairy topic. There are a LOT of nuances and variables. But it's an important concept, and one that every early-stage investor should know about.

Here's what I learned:

Quick recap on how investing typically works

In a typical fundraising round, you might commit $100k into a company that's valued at $1m post money. You now have 10% ownership in the company.

When the company raises their next round, the valuation has increased to $10m post-money valuation.

Your shares will be diluted by the new investors, but the company is now worth 10x more than when you first invested.

Because of dilution, the value of your $100k investment is not quite $1m now, but is on that order of magnitude – at least on paper.

How uncapped notes work

The example above is a best-case scenario.

But sometimes founders will raise on an uncapped note, which means that they are raising a round without setting a valuation.

Your shares will convert into equity at whatever valuation is set at the next priced round.

For example: You decide to invest $100k at the seed level on an uncapped note. You don't know if that $100k is buying you 0.1%, 1%, or 10% of the company.

Then the founder raises a Series A, and she and her lead investor agree on a valuation of $50m post.

That's when you'll find out what ownership you have in the company. In this case, your $100k has secured you 0.2% ownership of the company.

Why this isn't ideal

Investing in a pre-seed or seed-stage company is risky. Startups are most likely to fail in the first 1-2 years, so the earliest checks in are often the most high-risk.

They can also be extremely high-reward.

This is because early-stage companies have low valuations. So your money is buying you a bigger stake in the business.

In the previous example... you may have invested on an uncapped note believing that the company's valuation at that time was roughly $5m (based on current revenue and growth goals).

And $100k at a $5m post money valuation would net you 2% of the company.

But then you find out that your $100k check is actually for a company valued at $50m post-money valuation, which means you only own 0.2% of the company.

In this scenario, you're taking early-stage risks and receiving later-stage rewards.

When it might be worth the risk

For most VCs, investing on an uncapped note almost never makes sense.

This is because VCs have LPs (limited partners) to whom they have a financial obligation – often to get the highest return possible on their capital.

VCs can't just be investing other people's money without knowing what that investment will buy them. Nor can they take early-stage risks without the rewards that go along with that... their LPs just would not approve.

But for Angel Investors, it's a different story... because angels don't have a financial obligation to anyone.

If you want to invest in a company because you believe in the founder, or support the company's mission, or because all your friends are investing... you can!

There's another reason you may want to invest on an uncapped note: you see the company's potential and you want to reserve your spot on the cap table.

If a company is doing well enough that they can raise on an uncapped note, there's a strong chance they'll be able to raise their next round easily. And their lead investor may want to shut all other investors out of that round.

By investing today on an uncapped note, you're securing your spot as an investor in the future.

Lastly – you may want to invest on an uncapped note simply because you have conviction that the company will thrive. You see signals like:

50% month-over-month growth
established founder who raised a series A and will likely raise a Series B
strong product/market fit

Investing on an uncapped note isn't inherently a bad thing. But it is worthwhile to do your research into the company before making that call.