A valuation cap is something that applies to convertible notes. A convertible note is a security that is a hybrid of both debt and equity. Notes are issued in the place of priced equity, typically when a company is raising less than a million dollars and does not want to generate the legal expenses associated with a priced round. When the company issues a larger amount of capital, the notes will have the option to “convert” into the newly issued securities at a pre-set “discount” to the price of the follow-on round. These discounts typically range from 15 to 25 percent. However, in order to provide investors with some of the protections of a priced round, they add a”cap” to the valuation. The “cap” sets the highest valuation that can be used to determine the conversion price of the notes. For example: If the notes have a 20 percent discount and a 5 million dollar cap, and the next round is priced at $5 million, the notes will convert as though they were originally priced at $4 million. However, if the next round is priced at $10 million, the notes will convert at a $5 million price instead of $8 million, as $5 million was the “cap” on the price of the original equity. This allows companies to postpone setting a valuation while protecting the upside of investors to a reasonable extent, as the lower the conversion valuation, the more equity the investor receives.
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Topics: Venture Investing Academy