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.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 $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 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 $2.16, since the conversion share price would’ve been calculated using the $10M pre-money valuation instead of the $5M cap. Without the cap, 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.

Differing viewpoints on valuation caps

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, if their early-stage, higher-risk investment is what enabled the company to achieve a healthy pre-money valuation, then the investor deserves to be compensated for that—and the valuation cap is an excellent way to do that.

For founders, however, valuation caps can feel like a necessary evil, just one more thing to negotiate while wooing investors. Valuation caps can feel especially problematic, since one reason founders prefer convertible notes over fixed-price rounds is because they don’t have to set a value for the company. However, since many investors view the valuation cap as a proxy for the company’s current value, you can still essentially find yourself negotiating the company’s true value during a convertible note seed round.

That’s when you need to remember what Dan Shapiro said so eloquently in the recent blog post A Cap is Not a Valuation: Entrepreneurs should not let investors get away with the argument that they are. Caps protect investor’s upside risk by setting a floor on their purchase price, and that is it.

Guest blogger Joe Wallin is a leading startup lawyer in the Pacific Northwest and the founder of the Law of Startups. He represents companies from inception to exit, as well as investors, executives, and founders. His practice focuses on startups and emerging companies, angel and venture financing, and M&A transactions. Follow him on Twitter @joewallin