If your startup is considering funding of any kind, odds are you’ve heard mention of valuation caps. While they don’t impact you immediately, they do matter a ton for your investors who plan on being with you for the long haul. Investors are going to care about valuation caps and have it be part of the conversation, so it’s important to have a basic understanding of what they are and how they affect things.
And since so much of the buzz around valuation caps is based on scenarios where a company is succeeding and what that means for investors, you should be paying attention! We know you’re not going into an investment round with the intention to fail; your goal is to grow as a result of the investment infusion!
What Is a Valuation Cap?
In investing, a valuation, or conversion, cap may be placed on the price at which convertible notes (or SAFEs) will convert to equity in the future. The lower end of a valuation cap provides a holder of a SAFE/convertible note the option to convert their investment into stock. Valuation caps help ensure that an investment by an investor in a startup through a SAFE/convertible note converts to equity at a predetermined maximum price. Even if a company’s worth increases in future investment rounds, the maximum price for SAFE/convertible notes is capped. They can reward investors for early risk-taking.
This all sounds good but before we go any further, we need to make sure we define things a little more.
What is a Convertible Note?
A convertible note is, very basically, a loan from an investor for your startup. Convertible notes will turn into equity when a later trigger event occurs, such as profitable investment rounds in the future, maturity dates, or other exit reasons.
How Does a Valuation Cap Work?
Those investors holding a note with a valuation cap have the option to convert the remaining principal into stock at the share price in qualifying financing, or at the lower end of the valuation cap. Valuation caps are designed to help protect investors from losing out on a company’s growth between selling convertible notes and qualified financing, while also rewarding investors for taking the early, riskier investment. Valuation caps also protect investors from extremely low equity conversion rates in later valuation rounds for a business.
Savvy investors usually insist on a cap to help protect their investment should a company’s value start to soar. Our team at Sentiero is actively evaluating each opportunity with our portfolio investments to determine the right move for our partners in the fund. The direction is not always the same for each company based on the specific success of that startup, the market conditions, the mix of investors, and so many other factors.