How does valuation cap and discount work?

A “valuation cap” entitles note holders to convert the outstanding balance on the note into shares of stock at the lower of (i) the valuation cap or (ii) the price per share in a qualified financing (or, if there is a discount in the note, then the discounted price per share).

How do you set a valuation cap?

How to determine your valuation cap

1. the amount you’re raising on the convertible note (say $500k),
2. the conversion discount of the note (say 20\%),
3. the pre-money valuation cap of the note (say $4m),
4. the percentage of your company which the VCs will take in your Series A (say 30\%),

What is a cap in a convertible note?

A. A convertible note cap sets the maximum valuation at which the investment made via the convertible note can convert into equity. Investors in the convertible note typically get converted at the lesser of the valuation of the next qualified priced round and the cap.

Is a higher valuation cap better?

From an investor’s perspective, higher valuations reflect more expensive investments since investors must pay more for the same level of ownership. By investing at a lower valuation, convertible debtholders receive equity ownership at a cheaper rate than the current valuation.

What does a cap on a convertible note mean?

A convertible note cap sets the maximum valuation at which the investment made via the convertible note can convert into equity. Investors in the convertible note typically get converted at the lesser of the valuation of the next qualified priced round and the cap.

How do you decide on a valuation cap?

What is a safe or convertible note valuation cap?

A valuation cap provides SAFE or convertible note holders an opportunity to convert their investment into equity at the lower end of the valuation cap, or the price in subsequent funding rounds.

What is a valuation cap and how does it apply?

A valuation cap applies to convertible notes and SAFEs. A convertible note is a capital raising instrument that acts as a debt in the form of a loan made to the company. It then converts into equity in that company at a trigger event.

Should safes have a discount or a valuation cap?

At the time of conversion, the investor can take advantage of either the discount or the valuation cap — whichever is more favorable. SAFEs can include a discount, a valuation cap, both, or neither. However, it is not common for either to be absent, as that would discourage investors.

How does a safe or convertible note convert to equity?

Let’s say, for example, a company that enters into a SAFE or issues convertible notes to an investor with a valuation cap of $1 million. Should the company’s valuation at the next funding round reach $1.5 million, the investor’s SAFE or convertible note would convert into equity at the valuation cap price of $1 million.