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The argument you make exhibits the difference between traditional capital market financing and the venture capital community. At its very base, risk and return are correlated and by capping a convertible note, an investor is simply lowering his risk without the corresponding decrease in reward. Obviously a good thing for the investor, not so much for the entrepreneur who has constant risk but with a convert a diminished return. While embedded options do impact the pricing of the security the cap feature should as well!! While in a liquid market this pricing is an easier exercise, in the venture 'market' however, the vast number of financings are not priced by any market but rather as a result of a negotiation between two parties based upon looser principles. Thus if an investor is more skilled at negotiating or just plain has the upper hand when dealing with an entrepreneur, they can impose a cap feature. At the end of the day it is up to the entrepreneur to agree to it and if they don't like it, they can go back to the venture 'market' and seek capital. What is ultimately important is that the entreprenuer actually understands the implications of a cap feature for them.
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Sep 21, 2011