With convertible notes as a common way for startups to raise capital, investors should understand valuation caps, a mechanism designed to help early investors by setting a maximum company valuation at which their investment can convert into equity. In this blog, learn more about valuation caps, how they may be used, why they are important, and some key considerations for private market investors.

Understanding Valuation Caps

When an investor invests in a convertible note, that financial instrument starts as a short-term debt instrument that can convert into equity at a later date, typically triggered by a specific conversion event such as an equity funding round. Within a convertible note, a valuation cap is one investment term that sets a maximum company valuation for an investment’s conversion to equity. It’s important to note that a valuation cap is not an official valuation of the company, but rather a maximum valuation that can give early investors more favorable conversion terms in a future funding round. This works by converting into more equity shares for their investment – assuming the company’s valuation has increased above the valuation cap before the conversion. If the company’s valuation goes down below the valuation cap before the conversion event, the valuation cap is inapplicable, and the investor receive shares per the company valuation at the time of conversion.

When are Valuation Caps Used?

Valuation caps are typically incorporated into convertible securities during seed or bridge funding rounds, often at early-stages before a company has established revenue or even product-market fit. At this stage, avoiding the complexity of an equity round can benefit founders, while investors may seek out mechanisms to help mitigate some risks that come with investing, and especially early-stage investing.

Without a valuation cap, early investors may receive equity proportionate to new investors. Valuation caps can “reward” early investors for taking on risk at this stage of early-stage of the startup’s life.

Mechanics of Valuation Caps

To look at an example of how a cap can benefit investors, assume that an investor invests $100,000 into a startup through a convertible note with a $3,000,000 valuation cap. The company later secures Series A funding at a $9,000,000 pre-money valuation.

• The Series A price per share is calculated as $9,000,000 divided by the pre-money capitalization (for example, 5,000,000 shares), resulting in a price per share (PPS) of $1.80.
• The early investor’s conversion price is based on the $3,000,000 cap divided by the same capitalization, resulting in a PPS of $0.60.
• The early investor’s $100,000 investment converts into 166,667 shares, while a Series A investor who also invested $100,000 would only receive 55,556 shares at the $1.80 PPS.

This example demonstrates how a valuation cap can influence ownership percentages and reward the early investor, acquiring more shares at a lower price.

Some Key Considerations

For investors participating in funding rounds that involve convertible securities with valuation caps, they may want to be aware of the following key considerations.

Cap Negotiation

If negotiating investment terms, the level of valuation cap may come up in conversations. A lower cap can be more favorable for an investor. However, an excessively low cap may feel offensive to founders, as it can lead to equity dilution in a high-valuation future funding round. Investors should assess the valuation cap in the context of the company’s growth potential, market comparables, and the founding team’s execution capability.

Interaction with Discounts

Some convertible securities include both a valuation cap and a conversion discount. The conversion typically occurs using the mechanism that provides the lower price per share. Investors should understand how valuation caps and discounts interact to determine the final conversion price.

Dilution and Liquidation Preferences

When convertible securities convert into preferred stock, investors receive shares with a liquidation preference. If the conversion price is significantly discounted, the investor’s liquidation preference can far exceed their original cash investment. This can create misalignment with common shareholders in a liquidity event. Investors should be aware of how their discounted shares impact the overall capital structure and stakeholder dynamics.

Final Thoughts

Valuation caps are an important component of early-stage convertible securities. They can be used to help mitigate the risk for early investors while providing potential benefits if the company’s value appreciates when a conversion event occurs, converting the securities into equity. It’s important for private market investors to be aware of the use cases, mechanics, and key considerations of valuation caps before investing in a convertible security.

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Want to learn more about investing in startups? Check out the following MicroVentures blogs to learn more:

• Subsequent Funding Rounds: Follow On Investments
• Calculating a Startup’s True Runway
• Understanding Pro Rata Rights
• Checklist for VC Due Diligence

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The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.