top of page
Open Site Navigation

Valuation Caps: Necessary or Evil?

Are you considering using convertible notes for your next round of fundraising? If so, it’s important to know what a valuation cap is—especially since it may be the key to convincing investors to take a chance on your company.


Convertible notes are loans that convert to equity when the issuing company completes a subsequent round of financing. Unless the note contains a valuation cap or a discount (the latter is not discussed in this post), the equity issued for a convertible note is priced the same as the equity issued during this subsequent financing round.


What is a Valuation Cap?

A valuation cap limits the monetary value of the company that is used when converting notes to equity. So, if the value of your company exceeds the valuation cap when it’s time to convert notes to equity, the early investors will effectively get to buy shares at a lower price than newer investors, because the price per share for the early investors will be calculated based on a lower value (i.e., the valuation cap) for the company. This is a nice way to sweeten the pot for early, seed-round investors who are taking on more risk than those who invest later when the company is more stable.


Valuation Caps in Action

Let’s say you’ve issued $200,000 in convertible notes during a seed round and they’re set to convert to equity after a subsequent round of financing raises more than $1MM. The notes have no discount but do have a valuation cap of $5MM.


After you raise $2MM in Series A funding on a $10MM pre-money valuation, how is equity calculated for the notes that convert? Imagine that your pre-Series A cap table was as follows:


Pre-Series A Cap Table

Number of Shares

​% Ownership Interest

​Founders

​2,000,000

85.11%

​Option Pool

​350,000

​14.89%

2,350,000

​100%

Your post-Series A cap table would then look like this:


Post-Series A Cap Table

​Number of Shares

​% Ownership Interest

​Founders

​2,000,000

​68.67%

​Option Pool

​350,000

​12.02%

​Series A Investors

​468,483

​16.09%

​Series A (convertible note holders)

​93,896

​3.22%

​2,912,379

​100%

</