INSIGHTS

Valuation Caps, Discounts, and the Valuation of Your Startup

January 26, 2022

Disclaimer!

Although “valuation cap” has the term “value” at its root, it must first be noted that a valuation cap is not directly correlated to the value of your startup.

Then What is a Valuation Cap?

When a startup is in its early stages, the company’s value is difficult to determine and likely based on future opportunity as opposed to an economic metric.   At this point, investors often invest using convertible instruments. The two typical forms of convertible instruments are convertible notes and SAFEs.   In both instances, the instrument converts into equity of the company at the first “priced” or “equity” round of financing.   Often, that sale is required to meet a certain minimum investment amount defined in the convertible instrument, i.e.,  a “Qualified Financing”.

As an incentive for an investor to invest early, a convertible instrument will usually contain a valuation cap and a discount. An investor wants a premium or some kind of return benefit in exchange for investing early and without a discount or a valuation cap, the note would convert at the same terms as that of the Qualified Financing.

A valuation cap grants the investor ) the right to convert the balance of their convertible instrument into shares of the company’s stock at the lesser of:

1. The valuation cap, or
2. The price per share in the Qualified Financing (i.e., the financing event that triggers the conversion of the convertible instrument).

As mentioned previously, this valuation cap is not necessarily a valuation on the company, it is a tool used by investors which entitles them to some assurance that if the company appreciates between the time of their investment and the qualified financing, their investment will appreciate as well. Without such a valuation cap (or a discount, which is discussed below), the investor may have no incentive to invest early.

Here’s an Example of a Valuation Cap in Play:

Let’s say XYZ Corporation (“XYZ”) raises $200,000 in convertible notes with no discount, at an interest rate of 10%, and a valuation cap of $10 million that automatically converts upon a Qualified Financing of at least $1 million. Let’s also say there are 10,000,000  shares outstanding at the time.

Remember, at this point, the investor has the convertible note, but no actual equity or stock in XYZ; they only have the promise that the note could be converted into stock, eventually.

Now let’s say that one year later, XYZ sells $2.5 million in Series Seed Preferred Stock on a pre-money valuation of $15 million.

At that point, the convertible notes will be converted into shares of Series Seed Preferred Stock at a capped price of $1 per share. This was determined by dividing the $10 million cap valuation by the 10 million shares outstanding prior to the qualified financing ($10,000,000/10,000,000=$1 per share). Add in the 10% interest over 1 year to make the note convertible into $220,000 worth of Series A Stock. The investor will be receiving 220,000 shares of the Series Seed Preferred Stock upon conversion of the note.

On the other hand, the investors in the Qualified Financing will pay $1.50 per share, determined by dividing the pre-money valuation in the qualified financing of $15 million by the 10 million shares outstanding prior to the qualified financing.

Another way of looking at this is that instead of receiving the 220,000 shares of Series Seed Preferred Stock (($200,000 note + $20,000 interest)/$1.00 per share), they would have received only 146,667 shares of Series Seed Preferred Stock (($200,000 note + $20,000 interest)/$1.50 per share) had they only participated in the Qualified Financing.

What is a Discount?

A discount has the same desired outcome for an investor: when a Qualified Financing triggers the conversion of the convertible note, the holder of the convertible note (the earlier investor) will receive equity in the company at a “discount” of the price per share paid by investors in the Qualified Financing.

For example, if the same investor in XYZ above is issued a convertible note with a 25% discount and no valuation cap, the investor would have received 195,555 shares of Series Seed Preferred Stock (($200,000 principal +$20,000 interest)/(75% * $1.50) = 195,555).

Overview

Overall, valuation caps and discounts are just tools to entice early investors in your company. While they are meant to avoid having to put a value on your company early on, they often come with just as much negotiation.