In the world of startup financing, especially during early-stage fundraising, convertible instruments like convertible notes and Simple Agreements for Future Equity (SAFEs) are increasingly favored over traditional equity rounds. These instruments offer flexibility and speed, but their mechanics, particularly valuation caps and discounts are often misunderstood. This article demystifies how these terms operate and why they matter for both startups and investors.
Convertible Instruments: The Basics
A convertible note or SAFE is a form of investment where the investor provides capital to a startup with the expectation that the amount will convert into equity at a later financing round, typically when the company raises a priced round from institutional investors. Since the valuation of the startup at the time of the note/SAFE issuance is uncertain, investors rely on valuation caps and discounts to protect their upside when conversion happens.
This blog is a part of our Choosing the Right Investment Instrument for Startups Blogpost.
What Is a Valuation Cap?
A valuation cap sets a ceiling on the company’s valuation for the purpose of converting the investor’s note or SAFE into equity. This ensures that early investors receive equity at a more favorable price than later investors in the next funding round. Essentially, it rewards the investor for taking early risk by guaranteeing a minimum percentage of ownership, regardless of how high the company’s valuation climbs in the future round.
For example, if a note has a $5 million cap and the company raises its next round at a $10 million valuation, the investor’s conversion will be based on the $5 million cap. If the investor puts in $100,000, they receive equity as if the company were valued at $5 million, thus getting double the number of shares than they would have received at the $10 million valuation.
What Is a Discount?
A discount gives the investor a reduced price per share in the next round, usually expressed as a percentage (e.g., 20%). Instead of converting at the valuation paid by new investors, the early investor receives shares at a 20% discount to that price. This is another way to reward early investment, though it is often less advantageous than a valuation cap if the company’s valuation surges.
For instance, if the next round is priced at $10 per share and the investor has a 20% discount, their conversion price will be $8 per share. So, a $100,000 investment would convert into 12,500 shares, while later investors would only get 10,000 shares for the same investment amount.
Cap vs. Discount: Which One Applies?
Most convertible instruments include both a valuation cap and a discount, but they do not apply simultaneously. When conversion occurs, the investor gets the better of the two terms. That means the number of shares the investor receives is calculated under both methods, and the one that yields the greater equity stake is used.
To illustrate: Suppose a $100,000 SAFE has a $5 million cap and a 20% discount. If the priced round occurs at a $6 million valuation, the cap results in a better conversion price than the 20% discount, so the cap will apply. But if the round is priced at $5.5 million, the discount might yield a slightly better price per share.
Legal Implications for Founders
For founders, understanding the long-term dilution impact of valuation caps and discounts is crucial. A low valuation cap might make the deal attractive to early investors but could result in significant dilution when a larger priced round is raised. Founders should model different scenarios to anticipate the impact on their ownership.
Moreover, including both a cap and a discount can sometimes lead to negotiation fatigue or investor confusion. Legal advisors should work with founders to strike a balance between attractiveness to investors and preservation of long-term equity value.
Key Considerations for Investors
From the investor’s perspective, the valuation cap is a critical term, especially if they believe the startup’s valuation will significantly increase in the next round. It serves as a hedge against overvaluation and ensures a proportional reward for early risk. Investors should also ensure that the conversion mechanics (e.g., trigger events, definitions of “qualified financing,” etc.) are clearly defined to avoid disputes.
Conclusion
Valuation caps and discounts are fundamental tools in early-stage financing, designed to align the interests of startups and their earliest backers. While they offer simplicity compared to traditional equity rounds, the implications of these terms can be substantial. Founders and investors alike should approach them with a clear understanding and careful legal guidance. A well-structured convertible deal can build trust and set the foundation for successful future fundraising.
