Answer:
A valuation cap applies to convertible notes and SAFEs. A convertible note is a capital raising instrument that acts as a debt in the form of a loan made to the company. It then converts into equity in that company at a trigger event. A SAFE is a capital raising instrument under which an amount invested by an investor will convert into shares upon the occurrence of a subsequent funding round.
Both convertible notes and SAFEs are designed to convert equity upon certain trigger events, commonly at the next round of financing. Both instruments typically offer a discount and a valuation cap, which are investor-friendly clauses. If there is no offer for a valuation cap or discount, the instrument converts into equity at the price of the issuing company’s valuation in the next round. Further, it wouldn’t reward the early investor for the finance offered through the Convertible Note or SAFE.
A valuation cap results in the amount invested converting into equity at a maximum price (even if the value of the company at the next round of capital is higher than that cap). For example, if the valuation cap was $1 million but the company’s valuation at the subsequent funding round was $1.2 million, the amount invested would convert into equity at the $1 million valuation cap
Benefits of this cap include:
- If the valuation cap is lower than the actual valuation of the company at the next funding round, the investor will receive a greater proportion of equity. For example, if a company had a million shares on issue and had a valuation of $1 million, each share in the company would be worth $1. If an investor invested $100,000, that investor would receive 100,000 shares if the valuation of the company at conversion was $1 million. If the valuation of the company on conversion was actually $1.2 million (price per share is now $1.20), but the valuation cap was $1 million, the investor would still receive 100,000 shares ($100,000 / $1 per share) due to the valuation cap, rather than 83,333 shares in the absence of a valuation cap ($100,000 / $1.20 per share).
- It can defer setting a valuation of the company but still receive bridging finance between funding rounds through a convertible note or SAFE.
