What a Valuation Cap Isn’t

Background Reading

The always awesome Joe Wallin, together with Adam Lieb, recently wrote a post (link above) outlining how valuation caps on convertible notes work.  Founders should read it. In a nutshell, a “cap” is a limit on the valuation that a convertible note will convert at upon a “qualified financing.” Seems simple enough, but there are a few serious misconceptions about valuation caps that I feel someone should clear the air on.  Here’s what a valuation cap isn’t. 

1.  A Valuation Cap is Not a Valuation

Sort of.  In the strictest technical sense, a valuation cap is not a valuation.  It relates to future valuations.  It also doesn’t (generally) require a re-valuation of the FMV of your company’s equity for stock grant purposes.  And if a Series A ends up happening at a valuation below the cap, it’s not exactly considered a “down round.”

But in practice, investors and founders often treat caps like valuations.  When you come across an AngelList profile saying a startup is raising $500K at a $4M ‘valuation’, the majority of the time they mean they are issuing convertible notes with a $4M cap.  This “sort of but not really a valuation” aspect of capped notes is seen by some as the best of both worlds: you get to price a round without all the costs of negotiating  a full set of equity docs.  Others see it as having removed the main benefit of issuing notes (instead of equity) in the first place: deferring a valuation discussion to a future date.  Both sides have good points.

2. A Valuation Cap does not guarantee investors a minimum % of the Company

This is the issue that really needs the most clearing up.  I’ve seen angels make the claim that a valuation cap guarantees an angel a specific % of the Company post-Series A. This is just not true.  In a theoretical sense, a valuation cap guarantees a minimum pre-Series A % of the Company, but the note-holder never actually owns that % because the Series A money comes in alongside the conversion.

Take the example in Joe’s post:

  • $5M cap, $200K in notes (assume no interest for simplicity), $2M in new money at Series A at a $10M pre-money valuation.

I’ve seen investors do the following math:

  • % Ownership Post-A = Investment / (Cap + Investment)
  • So: $200K / ($5M + $200K) = ~3.8%
  • Therefore, they say, the note-holder should own 3.8% of the Company after the Series A.

The problem, of course, is that the new $2M from the Series A is nowhere in this equation.  That 3.8% is a percentage of the Company without the new Series A money coming in.

When you do the math correctly for the full Series A (see Joe’s post), the noteholder’s % comes out to 3.22% of the Post-A company. That’s the number the investor(s) will see on the cap table after conversion. And it could be higher or lower depending on the economics of the Series A.

This kind of confusion shouldn’t happen if you’re working with seasoned angels who’ve done several investments that have gone on to raise a Series A.  But if you’re not (often the case in Texas), make sure they understand the math of their own investment so there aren’t squeals when conversion time comes around.

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