What is a Valuation Cap?
What is a Valuation Cap?
You often find Valuation Caps in Convertible Notes or SAFEs. For this article, we are going to focus on the valuation cap of a convertible note.
If you’re considering convertible notes for your company, it’s essential to familiarize yourself with what a convertible note is and how a valuation cap affects the current shareholders and those buying in through the convertible note.
A convertible note is a loan which converts to equity when a triggering event occurs.
Typically, the trigger event is when the company completes the next round of financing. Here’s how it works: an investor lends money to a startup, the investor earns interest while the loan is outstanding; when the loan converts to equity, the value of the principal and interest are converted from loan into equity.
One of the main reasons early stage companies use convertible notes to raise capital is that the company can obtain funding without establishing a specific valuation on the business (which is needed when selling equity directly). This is of particular benefit for early stage companies because it gives you the chance to mature the company before determining the enterprise value at which you will sell equity. This helps to reduce dilution.
A valuation cap is used in a convertible note to give the noteholders a “ceiling” value at which their investment will convert and, in turn, that gives them a “floor” in regard to their ownership. With a valuation cap, they know that their money will convert from loan to equity at or below a certain dollar per share price established by the valuation cap.
Example of a Valuation Cap
Let’s say an investor invests in your company. They invest $1MM into the company via a convertible note that has a $10MM valuation cap. The capitalization table of the company is simple -- it has 10MM of common shares today held by two founders. Later, the company raises a Series SEED round of $3MM at a $15MM pre-money valuation. Without a valuation cap, the monies from the convertible note will buy in directly alongside the SEED money at $1.50 per share (=$15MM pre-money valuation / 10MM shares outstanding). This is illustrated in the middle cap table below. However, with the valuation cap, the noteholders will be able to buy in at $1.00 per share (=$10MM valuation cap / 10MM shares outstanding), which is illustrated in the right cap table below. Thus, with the valuation cap, the noteholders buy 1MM shares (assuming no interest), whereas without the cap they would only buy 666,667 shares.
Benefits of Valuation Caps
You may be asking, “Why would I want to risk selling equity at a discount?” Well, you do this because many convertible note investors will require a valuation cap in order for them to invest in the company via the note. You also do this because you want to incentivize those early investors (noteholders) to bring their money in early and fast.
If your company is in its early stage, an investor may be hesitant to invest in it. A valuation cap, however, may change that.
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Interested in Convertible Notes, SAFEs, & Valuation Caps?
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