Valuation Cap: What Does it Mean And Why is it Important?

Equity investments are not the only way a startup may choose to capture startup capital from investors. Convertible notes represent an alternative method of raising capital and can deliver a number of advantages.

Put simply, a convertible note is a loan from an investor to your startup or company. In the case of convertible notes, this loan will convert into equity when a trigger event occurs. These events can include the closing of successful future investment rounds, exit events, or the reaching of a maturity date.

A SAFE, or Simple Agreement for Future Equity, is a method of raising capital in which an investor provides capital to a startup or company on the condition that they have the option to convert their investment into shares when a specific trigger event occurs.

Similarly, to convertible notes, these trigger events can include exit events or successful qualifying rounds in which a company exchanges equity for capital. In many cases, a SAFE offers discounts at conversion in order to provide the investor with a larger number of shares for the capital they invest.

While the specifics of SAFEs and convertible notes differ, both convert equity when specific trigger events occur. In most cases, this trigger event is the next round of financing that a startup or company embarks on.

Both SAFEs and convertible notes offer investor-friendly clauses such as discounts and valuation caps. In the case that there is no offer for discounts or valuation caps, the SAFE or convertible note will be converted into equity at the price of the company’s valuation in the subsequent round.

A valuation cap provides SAFE or convertible note holders an opportunity to convert their investment into equity at the lower end of the valuation cap, or the price in subsequent funding rounds.

Put simply, a valuation cap ensures that an investor’s contribution to a startup or company via a SAFE or convertible note is converted into equity at a set maximum price. It’s important to note that this maximum price is limited — even in a scenario in which the value of a company during subsequent rounds is higher than the value specified in the valuation cap.

Let’s say, for example, a company that enters into a SAFE or issues convertible notes to an investor with a valuation cap of $1 million. Should the company’s valuation at the next funding round reach $1.5 million, the investor’s SAFE or convertible note would convert into equity at the valuation cap price of $1 million.

Valuation caps provide investors with an incentive to invest early in promising startups. If, for example, the valuation cap is half than the valuation of a startup or company at the time of the next funding round, the investor will receive twice the amount of equity in return for their investment.

A lower valuation cap will provide an investor with a potentially higher equity percentage at the next funding round. A valuation cap also protects investors from disproportionately small equity conversion percentages during subsequent valuation rounds.

Valuation caps provide investors with incentives to invest in companies as well as a degree of risk minimization. Startup founders and entrepreneurs can leverage the benefits of valuation caps to attract investors when other capital raising methods, such as traditional equity investments.