Valuation cap guide for founders

What is a valuation cap?

A valuation cap is a provision in convertible notes (a short-term debt that converts into equity) that sets the maximum valuation of the company at which the investment will convert to equity. It's designed to protect early investors by guaranteeing they receive a minimum percentage of ownership when the note converts, regardless of how high the company's valuation grows.

For example, say an investor puts $100,000 into your startup using a convertible note that has a valuation cap of $5 million. Later, during the next round of funding, your startup's valuation rises to $10 million.

Without a valuation cap, the investor’s $100,000 would convert at the $10,000,000 valuation:

$100,000 / $10,000,000 = 1% ownership

With a valuation cap of $5,000,000, the investor’s $100,000 converts at the lower valuation:

$100,000 / $5,000,000 = 2% ownership

How do valuation caps work?

A valuation cap sets a maximum company valuation at which an investor's convertible debt (or SAFE note) will convert into equity. It acts as a price limit, protecting early investors and noteholders by making sure their ownership stake is based on a lower price if your company grows significantly before conversion.

Valuation caps come into play during a qualifying financing event, typically a priced equity round (series A funding). Here's how the process unfolds:

• Setting the cap: The valuation cap is negotiated during fundraising and included in the agreement. For example, a valuation cap of $5 million means the investor's shares will be priced as if the company's valuation is $5 million, even if it later reaches a higher valuation.

• Conversion: When a future equity round or liquidity event (like an acquisition) occurs, the convertible note converts into equity using either the valuation cap or the actual company valuation, whichever is lower.

The valuation cap ultimately influences how much equity an investor receives. Those with a lower valuation cap convert their investments at a lower share price, giving them a larger ownership stake. However, it's important to keep in mind that because early investors secure more shares, this can lead to greater equity dilution for founders and later investors.

For instance, if your company raises funds at a $10 million valuation, but an investor has a valuation cap of $5 million, their shares will be priced at the $5 million valuation. This means they'll receive a larger percentage of ownership than they would without the cap.

Calculating conversion: caps vs. discounts

In the context of convertible notes, a discount is a percentage reduction on the price per share that early investors receive when converting their investment into equity during a subsequent round of funding.

For example, if a company raises a new financing round at $1 per share and the convertible note has a 20% discount, the early investor would pay $0.80 per share. However, while both caps and discounts incentivize early investment, they work differently:

• Valuation cap: Sets a maximum conversion price, regardless of the actual company's value. The formula for this is:

Investor's ownership = investment amount valuation cap

• Discount: Offers a percentage reduction on the share price at conversion. The formula to calculate this is:

Discounted share price = Share price in the funding round (1 - discount rate)

Here's an example to illustrate this relationship:

• Investment: $100,000

• Valuation cap: $5 million

• Discount: 20%

• Actual company valuation: $10 million

Valuation cap conversion

The investor's ownership is calculated using the valuation cap:
$100,000 / $5,000,000 = 2% equity

Discount conversion

The discount reduces the effective valuation for the investor:

$10,000,000 x 0.8 (20% discount) = $8,000,000

$100,000 / $8,000,000 = 1.25% equity

In this case, the investor would choose the valuation cap because it offers a better deal with 2% equity financing, compared to 1.25% under the discount.

Advantages

Valuation caps offer several benefits, making them popular for early-stage fundraising. These include:

1. Easier fundraising: Caps can make it easier to attract early-stage venture capital without immediately diluting equity.

2. Flexibility: Founders can defer precise valuation discussions to later stages when the company has more traction.

3. Cash flow management: Convertible notes with caps allow companies to better manage cash flow in the early stages than priced equity rounds.

Disadvantages

While valuation caps offer various advantages, they come with challenges that early-stage entrepreneurs should consider carefully. Some of these include:

1. Potential for significant dilution: If the company grows rapidly, founders may give away more equity than anticipated due to the cap.

2. Complicated cap table: Multiple notes with different caps can lead to a complex capitalization structure.

3. Misaligned incentives: Caps might incentivize founders to keep valuations low, potentially conflicting with growth goals.

By carefully considering these advantages and disadvantages, founders can make informed decisions about using valuation caps in their early-stage financing strategies, balancing the need to attract investors with long-term ownership and control considerations.

Wrap up

Understanding valuation caps is essential for structuring early-stage financing that attracts new investors without compromising your long-term ownership goals.

As you navigate fundraising, consider seeking advice from experienced mentors or legal professionals to confirm that your financing strategy aligns with your company's unique needs and growth trajectory. And when it's time to leverage a business bank account to help take your startup to the next level, consider Rho.

Our finance platform helps you manage cash and automate finance busywork, so you can focus on growing your business.