A valuation cap limits the price at which a SAFE (Simple Agreements for Future Equity) may eventually convert to equity ownership. This pre-negotiated sum "caps" the conversion price once shares are issued and represents the highest valuation at which an investor can convert a SAFE into equity. Startup entrepreneurs frequently propose value caps as incentives to entice early investors because investing in startups involves considerable risk.
It applies to conventional fundraising methods and SAFEs, financing tools that grant early investors the same right to future equity in the company as more conventional funding methods while being easier, less expensive, and quicker to execute.
What Is a Valuation Cap?
A valuation or conversion cap is put on the price at which convertible notes or SAFEs will convert to equity in the future (if we're dealing with convertible notes). The lower end of a valuation cap, or the price in subsequent funding rounds, gives holders of SAFE or convertible notes the option to convert their investment into stock.
A valuation cap ensures that an investor's investment in a startup or business through a SAFE or convertible note is converted into equity at a predetermined maximum price. It's critical to remember that this maximum price is restricted, even if a company's worth increases in succeeding rounds and exceeds the valuation cap.
What is a Convertible Note?
A business may obtain initial cash from investors in various ways, including equity investments. Using convertible notes as a different way to raise money has various benefits.
A convertible note is essentially a loan from an investor to your startup or business. As with convertible notes, this loan will turn into equity when a trigger event occurs. The conclusion of profitable future investment rounds, exit occasions, or the upcoming maturity date is a few examples of these events.
How Does a Valuation Cap Work?
Holders of notes with a "valuation cap" have the option to convert the remaining principal into stock at the lower of- (i) the valuation cap or (ii) the share price in a qualifying financing (or, if there is a discount in the note, then the discounted price per share). It is not a value of the business based on its current assets or plans. It is designed to ensure an investor doesn't lose out on a company's considerable growth between selling convertible notes and qualified financing. In all fairness, the investor should feel somewhat secure knowing that even if they invest at a time when the firm has little value, the note won't convert at a ridiculously high price, depriving them of the opportunity to benefit from the full potential of their initial investment.
Additionally, a valuation cap shields investors from abnormally low equity conversion rates in later valuation rounds. In general, sophisticated investors insist on a cap since, without one, their investment will lose value if the company's value begins to soar. Discounts and caps cannot be used concurrently; an investor must decide between the two at the subsequent round and choose which will be more profitable for them financially.
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A Valuation Cap from the Viewpoint of an Investor
From an investor's perspective, this conversion of notes or SAFEs into equity will occur during a subsequent investment round, when another investor will likely participate. Naturally, the new entrant will want a piece of the action, or equity, in return for their investment. The valuation cap's purpose is to best protect or reward initial investors in the future. Early investors, in particular, can benefit from the value cap since it lessens the risk they took when they entrusted their money to a project that was taking place in an extremely risky environment.
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A Valuation Cap from the Viewpoint of a Startup
As was emphasized at the beginning of this post, the valuation cap is crucial for entrepreneurs. Its significance is focused on a point that has been purposefully left out up until this point. What is that, then? Well, it's the valuation itself, strange as it may sound. The "lack" of any valuation in these initial seed rounds, to be more accurate, is what makes this term so important.
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A "conflict of interests" between entrepreneurs and investors because of the valuation cap
In the preceding part, we concentrated on investors and startups eventually reaching an investment agreement despite not having a specific estimate of the firm valuation. They do, however, have a valuation cap. It is seen as a reflection of how much the startup is worth when investors invest. Investors want that value to be as low as possible.
Considering that they will eventually need to convert their notes or SAFEs into equity, they wish to reduce the risk of overpaying. In conclusion, investors often attempt to pull the value down. On the other hand, startups will now work to increase that value. Naturally, they must safeguard their business against potential interest dilution.
More specifically, there is a good likelihood that a firm will have a lesser percentage of equity when the time comes for convertible notes or SAFEs to be converted into equity, which occurs during a post-money valuation, especially in one particular instance. Of course, this will happen when the initial valuation cap turns out to be significantly lower than the valuation determined at that time.
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Benefits of Valuation Cap
Investors are encouraged to make early investments in potential firms by valuation caps. For instance, the investor will receive twice as much equity in return for their investment if the value cap is half that of a startup or firm at the time of the subsequent funding round. An investor may receive a bigger equity stake in the following funding round with a lower valuation cap. Additionally, a valuation cap shields investors from abnormally low equity conversion rates in later valuation rounds.
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Drawbacks of Valuation Cap
However, valuation caps may have disadvantages. As the maximum price is constrained, the startup value in later rounds could surpass the cap, which would be bad for the investor. Suppose a company's valuation at the time of the next fundraising round reaches $2 million, for instance, and an investor's SAFE has a valuation cap of $1 million. In that case, the SAFE will still convert into equity at the cap price of $1 million. Founders frequently provide early investors with discounts in addition to caps as restitution for this.
Key Terms
- Capital Asset Pricing Model (CAPM): The Capital Asset Pricing (CAPM) Model is the most commonly utilized risk/return standard used to estimate the equity price of capital.
- Debt Financing: Raising funds for a company through loans or by administering bonds.
Conclusion
The valuation cap is one of the seed investment agreements' most important provisions and instruments. You could consider it a source of conflict between you and your investors. Even yet, it unquestionably acts as a tool with a track record of being quite effective at raising funds. Whatever the kind of agreement, convertible notes or SAFEs, such investments ultimately continue mostly due to a value cap. It protects your investors from overpaying for shares of your startup at a later stage while also serving the interests of your startup. The mission of ContractsCounsel is to assist people and businesses in finding reasonably priced legal counsel.
