What is a Valuation Cap?

valuation capBy Adam Lieb and Joe Wallin

If you are contemplating raising money through the issuance of convertible notes, you might be wondering – what is a valuation cap?

Convertible notes are designed to convert into equity of the issuing company upon a subsequent financing (usually referred to in the note as a “qualified financing”; e.g., when the company raises more than $1M dollars in new capital). Without a cap or discount (not discussed here), the notes would typically convert into the issuing company’s equity in the subsequent financing at the same price as the equity issued in that financing.

For publicly available example promissory notes, you can see here:

A “valuation cap” entitles note holders to convert into equity at the lower of the valuation cap or the price in the subsequent financing. You can find an example of this provision in both of the above documents.

  • In the Alliance of Angels note, you can find the valuation cap language in Section 4. The pertinent language reads as follows:

the outstanding Principal Amount and accrued interest under the Notes shall automatically convert into shares of the same series of preferred stock as is issued in the Qualified Financing at a conversion price equal to the lesser of (a) the price obtained by multiplying (i) the price per share paid in the Qualified Financing by (ii) the applicable Conversion Percentage (as defined below); or (b) the price obtained by dividing (i) [VALUATION CAP] (the “Valuation Cap”).

  • In the TechStars note, you can find the language is as follows:

outstanding principal balance of this Note shall automatically convert in whole without any further action by the Holder into such Equity Securities at a conversion price equal to [the lesser of (i)] ____% of the per share price paid by the Investors [or (ii) the price equal to the quotient of $__________ divided by the aggregate number of outstanding shares of the Company’s Common Stock as of immediately prior to the initial closing of the Qualified Financing (assuming full conversion or exercise of all convertible and exercisable securities then outstanding other than the Notes)]

Example

Suppose you have raised $200,000 in convertible notes.  The notes have no discount but a valuation cap of $5M, and they are set to convert upon a subsequent raise of greater than $1M.  You then succeed in raising $2M in Series A funding on a $10M pre-money valuation of $10M.

What happens to the notes?  At what price do they convert?  How many Series A shares do you issue for the note amounts?

Let’s suppose your pre-Series A cap table looks like this:

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

 100.00%

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

 100.00%

The price per share for the convertible note holders converting into Series A will be the valuation cap of $5M divided by the same 2,350,000, or $2.13 per share (rounding up).  Assuming a $200,000 loan, the convertible note holder will receive 93,896 shares (assuming no interest on the notes, for the sake of simplicity).

The price per share for the Series A investors will be the $10M pre-money divided by the fully diluted number of outstanding shares immediately prior to the closing (2,350,000), or $4.26 per share (rounding up).  Assuming a $2M investment, the Series A investors will receive 469,483 shares.

You can see from these tables the benefit of the “cap” to the convertible note holders.  Without a cap in this instance the debt holders would have received half as many shares. This makes sense because in my example the valuation cap was exactly ½ of the pre-money valuation in the subsequent financing.

You can also see why debt holders like valuation caps.  They especially like them when it is their opinion that it is their early stage debt money that allows the company to achieve the high pre-money valuation on the subsequent fixed price round. You can certainly see the view point of the convertible note holders in these situations that they ought to participate in that healthy pre-money valuation through the cap mechanism if it was their funds which made it possible.

From the company’s point of view, valuation caps can be a pain, because they are one more thing to negotiate.  One of the reasons you do a convertible note in the first place, rather than a fixed price round, is to avoid having to set a value for the company.  If the cap is supposed to represent the current value of the company (the typical investor view), then you haven’t accomplished putting off the valuation negotiation at all, and it is possible you might get bogged down in an argument about it.

[1] See this blog post from Dan Shapiro, “A Cap is Not a Valuation

Founder viewpoint:  Caps are a necessary evil when raising convertible notes in the current climate. Valuation caps limit crazy situations, for example, the valuation goes up 5-10x. In these situations, without a cap the early stage investors would not be adequately rewarded for their risk. Therefore, they need a cap to put a floor on their price. In most situations a discount on the subsequent round will reward those investors. For example an uncapped note + a 50% discount at the seed stage will ensure that seed stage investors see a 2x paper return on the next round. Caps are NOT valuations.[1]  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.

About Joe Wallin

Joe Wallin focuses on emerging, high growth, and startup companies. Joe frequently represents companies in angel and venture financings, mergers and acquisitions, and other significant business transactions. Joe also represents investors in U.S. businesses, and provides general counsel services for companies from startup to post-public.
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  • José Ancer

    Great post, gentlemen. One thing I see a lot of people get tripped up on is what exactly a cap provides to the investor in terms of ownership. Inexperienced angels (and founders) will often think the cap guarantees them a minimum % of the post-Series A company. So they do the math with % = 200K/$5.2M and think the outcome is a guarantee of Post A ownership, regardless of the A round deal terms.

    I often have to explain to them, after modeling, that the % (3.8ish % in this case) is a PRE-Series A percentage. It provides a ceiling on the conversion price, guaranteeing in a theoretical sense the % the holder will own if all notes converted at the price, but no A ever happened. But once that new A money goes in, the % goes down. I think I might write about this soon.

    • http://adamlieb.me/ Adam Lieb

      Good point. Another thing people often forget about is that interest typically gets converted as well. If you have a note at 6% for 2 years, that is a consequential piece of equity. That doesn’t factor into the math as much as it probably should.

    • http://startuplawblog.com/joewallin Joe Wallin

      Thanks for sharing Jose. Yeah, it is funny with an instrument like this that there can be so much confusion. I tell people that notes are deceptively complex.