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:
20 percent discount and a $5 million 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. In fact we recommend that if you are EVER investing in a convertible note, that it should ALWAYS have a valuation cap.
“Uncapped” notes can be very dangerous for investors, because if there is a significant increase in valuation, you will not financially benefit from it as much as you should. If there is no qualified financing prior to a liquidity event, you may end up simply being repaid your capital and interest, while the equity holders of the company enjoy big financial returns. To learn more about valuations and how we evaluate them, check out our article on “Startup Valuations Demystified”.