Speaking at an angel investors conference last week I took a bold stand and begged the attendees to say no to capped convertible notes. It may seem an odd thing to take a stand against. Sure, take a stand against racism, homophobia, cilantro, but uncapped notes? What's the big deal? That may well be the very attitude that has gotten us into this mess. Capped convertible notes are a lazy solution for people who don't want to choose between debt and equity. They are the worst of both worlds. So I am taking a stand. Just say no to capped convertible notes!
Let's start with the fact that the vast majority of investors would prefer a priced equity round over a convertible note. (I'm leaving open the possibility that there are investors out there who, when given the choice, would prefer a convertible note -- but, frankly, I can't imagine who they are or why they would prefer debt to equity in an early stage startup). Equity takes the guesswork out of a financing -- X dollars invested will buy you Y percent of the company. Period. Better yet, once an angel has made an equity investment, her incentives are perfectly aligned with the entrepreneur in whom she has just invested. Entrepreneur and investor alike will strive to make the company as valuable as possible and to raise future money at a price that is significantly higher than that of the last round of financing.
Despite the certainty of equity financings, entrepreneurs often prefer to raise money with convertible notes. In a convertible note financing, the investment an angel makes in the company (technically a loan) will convert to equity in the next round of financing at the price of that round (usually minus some discount). With any luck, the entrepreneur is then able to use that money to grow his business, increasing the value of the company, and thereby decreasing the percentage of the company that the angel investor will ultimately own. Therein lies the appeal of an uncapped note to an entrepreneur -- the more progress the entrepreneur makes, the less of the company he has sold in the angel round of financing.
In light of the the disparate incentives built into these two financing vehicles, it is not surprising that entrepreneurs and investors are often at odds over how to structure an investment. But rather than debate the merits of the respective approaches and choose the vehicle that makes the most sense in the context of that particular financing, entrepreneurs and angels often "compromise" and use a hybrid of the two, the capped convertible note. The capped note converts in a future round of financing at the price of that future round, so long as that price is no higher than the specified cap. In the event that the round of financing gets done at a price higher than the cap, however, the note converts as if the financing had been priced at the established cap.
The capped note may seem reasonable enough at first blush, but the end result can have meaningful disadvantages, particularly for the entrepreneur. Capped notes are the financing equivalent of "heads you win, tails I lose." By capping a convertible note, you are saying that a financing will get done at no greater price than X. So if the company does well, the maximum price that an angel investor will pay is set. However, if the company stumbles, the investor will get the advantage of a financing price below the established cap. Given that, the entrepreneur might as well have done an equity round in the first place. At least the equity round would not have carried with it the downside risk of a capped note.
The capped note also has negative consequences in the event that a company raises money at a price significantly higher than the cap. Imagine an entrepreneur raises an angel round of $1M at a $5M cap. The least that the angel investors will ever end up owning of the company is 20% ($1M/$5M). In the event that the Series A round gets done at, say, a $20M valuation (4 times the cap), the angel investment will convert into the equivalent of $4M in Series A Preferred Stock. While that was the bargain in the angel round, it has an unintended consequence -- rather than getting $1M in liquidation preference, the angels now get $4M in preference. Again, the end product is worse for the entrepreneur than if he had simply priced the round in the first place. 
None of this is intended to argue the relative merits of priced rounds or uncapped convertible notes (although I am a firm believer in priced rounds). It is simply intended to point out the clear disadvantages of capped notes. Next time you are negotiating an investment in an angel round -- whether you are the financier or the entrepreneur -- don't fall back to the capped note as a supposed middle ground. It is the worst of all worlds. Just say no to capped convertible notes!
 There is a temptation to argue that caps on convertible notes are higher than the price at which an equity round might get done. Therefore, there is still economic advantage to a capped round over a priced round. But there is no empirical evidence to that effect. I would argue that the price an angel would pay in an equity round is indistinguishable from the price at which an entrepreneur is willing to cap a convertible note round. If that is the case, entrepreneurs should prefer equity rounds to capped notes 100% of the time.