Is it better to have a higher or lower valuation cap?

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.

Does a convertible note need a valuation cap?

The Valuation Cap is the most important term of a convertible note or a SAFE. It entitles investors to equity priced at the lower of the valuation cap or the pre-money valuation in the subsequent financing. The valuation cap sets the maximum price that your convertible security will convert into equity.

What is a cap on convertible debt?

A convertible debt cap, also known as a valuation cap, is the maximum amount at which an investor will change his or her investment into equity.

What is a SAFE post-money valuation cap?

With a post-money SAFE, an investor gives you money and effectively “locks in” the percentage of your company that they’ll own at the moment you convert their SAFE into shares. The valuation cap on this SAFE is $10 million.

How do I choose 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\%),

How do convertible notes affect stock price?

Conversion Discount: When the convertible notes convert to equity in the event of a qualified financing, not only do the note holders get credit for both their original principal plus accrued interest to determine how many shares they receive, they also generally get a discount to the price per share of the new equity.

How do you calculate the valuation cap for a convertible note?

Why is there a $4m cap in the convertible note?

“We put the $4M cap in the convertible note to protect our early investors in the event their investment allows us to skyrocket and raise an equity round in the future at a high valuation. But remember that with your 20\% discount, a $4M valuation in the future would allow you to convert into equity at a $3.2M valuation.

What happens if I don’t have a cap on my notes?

If you didn’t have a cap, you would simply give a fixed (say 20\%) discount when the note converts into shares. But when you have a cap, and your Series A valuation hits the cap, you’re fixing the price for the early investors, while the incoming Series A investors might be paying a lot more per share.

What are convertible notes and how do they work?

To reward the investor, the terms of convertible notes may include a discount to the market value of a share at conversion. This allows the investor to receive shares at a lower price than what they are worth. Using convertible notes to raise capital is attractive to startups because it can be simpler and quicker than an equity investment.

When do investors take advantage of the cap on notes?

In this case, the investor only gets to take advantage of the cap if the company raises their future equity round at a valuation higher than $5M (20\% discount off $5M = $4M). So any valuation lower than $5M gives the investor exactly the same equity as if the note didn’t have a cap at all.