Convertible debt is the trendy way to finance seed-stage startups these days. It allows early investors to essentially "punt" on determining the true valuation of the company at an early stage, while still ensuring that they get a decent deal when a valuation does get determined.

The way it works: instead of negotiating over true valuation early on, the seed investor hands over the cash as a debt instrument (so the startup technically owes the investor the money they paid), under the agreement that if the startup later raises a "real" (venture) investment round, the debt converts to equity at the price of the later round.

Of course, to avoid screwing the seed investors over, they typically insist on a "valuation cap" -- maximum valuation -- (so if you later raise venture at $10mm, but the cap was $5mm, the seed investors get twice as much equity as the venture investors per dollar paid). But if the venture investors only pay for a $5mm valuation, then they get the same equity-per-dollar as the seed investors.

This is exactly what I wanted to know, thank you!

This seems like a reasonably good explanation:

http://www.askthevc.com/wp/archives/2011/09/convertible-debt...

Valuation.

Think "Market Capitalization" not "top" or "limit"

No, "limit" is the correct interpretation. For a convertible debt investment, it's the maximum valuation by which the debt can be converted to equity. (And therefor a minimum percentage of the company that the investor will receive.)