A valuation cap sets a maximum company valuation for early-stage investors using convertible instruments, ensuring they receive favourable equity conversion terms even if the company's value skyrockets before the next funding round.
A valuation cap is a contractual term in early-stage investment documents that sets a maximum company valuation for the purpose of converting convertible instruments into equity. It provides investor protection by ensuring that early backers receive shares at a predetermined valuation ceiling, regardless of how high the company's valuation might rise before the next funding round.
When you accept investment through a convertible note or SAFE agreement with a valuation cap, you are essentially promising that the investor will convert their investment into equity at the lower of two prices: either a discount to the next round's valuation or the valuation cap, whichever is more favourable to the investor. This mechanism rewards early risk-taking by preventing dilution if your company experiences explosive growth.
For founders, understanding valuation caps is crucial when negotiating early-stage funding. A lower valuation cap means investors get more equity for their money, whilst a higher cap preserves more ownership for you. Striking the right balance requires assessing your company's growth potential against the investor's risk appetite.
A valuation cap functions as a ceiling price for conversion. If your company's next equity financing round values it at €10 million, but the valuation cap in your early investor's agreement is €5 million, their investment converts as if the company was valued at €5 million. This means they receive twice as many shares as they would have without the cap, rewarding them for investing earlier when risk was higher.
The cap only comes into effect when the conversion triggers, typically during a priced equity round. At that point, the investor's investment converts into shares using either the discounted price or the capped valuation, whichever produces more shares. This ensures early supporters are adequately compensated for backing your vision before the business had proven its value.
It is important to note that valuation caps do not set an actual valuation for your company. They are merely a mechanism for determining conversion price. Your company's true valuation emerges during formal fundraising rounds based on market conditions and investor demand.
A valuation cap and a discount are two different mechanisms used in convertible instruments to reward early investors. Whilst both provide favourable conversion terms, they operate differently. A discount gives investors a percentage reduction (typically 20-30%) off the price per share in the next funding round.
The valuation cap, by contrast, sets an absolute maximum valuation for conversion. In many convertible agreements, investors receive the better of either the discounted price or the price based on the valuation cap. This "most favoured nation" approach ensures early backers get the most advantageous conversion possible.
Investors insist on valuation caps to protect against scenario risk. Without a cap, an early investor could put money into a startup at a €2 million valuation, only to see the company raise its next round at a €20 million valuation a year later. The investor would then receive shares priced at the €20 million valuation, receiving far fewer shares than anticipated.
A valuation cap mitigates this risk by guaranteeing that the conversion will happen at a reasonable valuation relative to the investor's early entry point. This protection is particularly important for seed investment rounds where the company's future valuation is highly uncertain.
A valuation cap directly impacts founder dilution because it determines how many shares early investors receive upon conversion. A lower cap means more shares issued to investors, resulting in greater dilution for founders. However, this must be balanced against the capital raised and the investor's contribution beyond just money.
When negotiating valuation caps, consider your company's realistic valuation trajectory. If you expect rapid growth, a higher cap may be acceptable. If growth might be slower, a lower cap might be necessary to attract investment. Remember that while dilution matters, having sufficient capital to execute your business plan often creates more value for everyone.
Once signed, valuation caps are generally binding contractual terms that cannot be changed without all parties' consent. However, during subsequent fundraising rounds, you might encounter situations where new investors want to adjust existing caps as part of their investment terms.
This typically occurs when the new round's valuation is significantly higher than existing caps would suggest. In such cases, renegotiation might involve offering existing investors additional benefits or creating a new instrument with modified terms. Any changes require careful legal structuring and unanimous investor approval.
If your convertible instrument has no valuation cap, investors convert at either the discount rate or the next round's actual valuation. This exposes early investors to significant risk if your company's valuation increases dramatically before conversion. Many sophisticated investors will refuse to invest without some form of protection, either through a cap or a substantial discount.
Valuation caps typically apply to the next qualified financing round, which is usually defined as a priced equity round meeting certain minimum criteria. If multiple convertible instruments exist with different caps, they convert in order of priority, with the earliest investments typically having the most favourable terms.
During due diligence for later-stage funding, investors will carefully examine your cap table to understand how existing convertible instruments will convert. Complex cap structures with multiple caps can complicate fundraising, so maintaining clear records is essential.
Valuation caps are common in SAFE agreements and some convertible notes, but not universal. Some early-stage instruments use only discounts, whilst others combine both mechanisms. The choice depends on market conditions, investor preferences, and founder negotiation leverage.
In competitive fundraising environments with multiple investor interest, founders may negotiate higher caps or eliminate them entirely. However, in more challenging markets, investors may insist on aggressive caps to protect their downside risk.
