Convertible Note Valuation Caps: Necessary or Evil?
- Lighter Capital
- Apr 25, 2023
- 4 min read
Updated: Oct 1
Are you considering using convertibles 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. The equity issued for a convertible note is priced the same as the equity issued during this subsequent financing round—unless the note contains a valuation cap.
What's a Valuation Cap on a Convertible Note?
A valuation cap limits the company valuation that's used when converting notes to equity. In other words, 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 startup investors who are taking on more risk than those who invest later when the company is more stable.
GO DEEPER: 18 FAQs About Convertible Notes
How a valuation cap works
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 $1M. The notes have no discount but do have a valuation cap of $5M.
After you raise $2M in Series A funding on a $10M 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% |
To calculate the price per share for converting notes into Series A equity, you divide the valuation cap of $5M (which is lower than the current value of the company) by the original 2,350,000 shares. In this case, the price is $2.13 per share (rounding up).
So, if a convertible note holder had invested $200,000 (assuming no interest earned, to keep the math simple), they would receive 93,896 shares.
By contrast, the share price for Series A round investors would be calculated using the $10M pre-money valuation divided by the fully diluted number of outstanding shares immediately prior to the closing (2,350,000).
So, in this case, the share price for Series A investors would be $4.26 per share (rounding up), and a Series A investor who invested $2M would receive 468,483 shares.
These tables show the benefit of the valuation cap for convertible note holders.
Without this cap, the value of each share at the time of conversion would’ve been $4.26 instead of $2.13, since the conversion share price would’ve been calculated using the $10M pre-money valuation instead of the $5M cap. Additionally, the note holders would have received only half as many shares, since the valuation cap was exactly half of the actual pre-money valuation at the time that the subsequent financing round was completed.
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Why Caps Are a Necessary Evil
Valuation caps offer more advantages to investors than they do startup founders. It’s easy to see why convertible note holders like valuation caps, especially when they believe that their early-stage investment will allow a startup to achieve a higher pre-money valuation (compared to the valuation cap) before the next round of financing is completed.
From the investor’s point-of-view, they deserve to be compensated for their higher-risk investment that helped the early-stage startup achieve a strong company valuation. A valuation cap is an excellent way to do that.
For founders, however, valuation caps can be a necessary evil—it's just one more thing to negotiate when wooing investors and trying to raise capital. And, a big advantage of raising convertible notes, instead of a priced equity round, is skirting a valuation negotiation. One could view the valuation cap as a proxy for the company’s current value, which puts pressure on founders to negotiate the company’s true value during a convertible note round.
Even though a cap could possibly influence perceptions in future fund raises, it is not the actual valuation of your company. Dan Shapiro addressed this eloquently in his blog post A Cap is Not a Valuation:
"Entrepreneurs should not let investors get away with the argument that they are making. Caps protect investor’s upside risk by setting a floor on their purchase price, and that is it."
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