What Is a Valuation Cap and How Does It Work?

A valuation cap is a protective measure for early investors in a startup, establishing a maximum company valuation at which their initial investment will convert into equity during a future funding round. It provides early investors with a more favorable conversion price, compensating them for the higher risk of providing capital in the company’s early stages. This term is common in agreements designed to attract initial capital without immediately assigning a fixed valuation to a nascent company.

How Valuation Caps Function

A valuation cap works by setting a ceiling on the company’s valuation for the purpose of converting an early investment into equity. When a startup raises a subsequent qualified financing round, such as a Series A, the valuation cap determines the effective price per share for the early investor. If the company’s pre-money valuation in the new financing round exceeds the valuation cap, the early investor’s shares convert at a price calculated using the cap, rather than the higher valuation of the new round.

Consider an example where an early investor provides $100,000 to a startup with a valuation cap of $5 million. When the company raises its Series A round at a pre-money valuation of $20 million, with 10 million shares outstanding, the price per share for the new investors is $2.00 ($20 million / 10 million shares). For the early investor, the valuation cap is triggered because $20 million exceeds the $5 million cap. The conversion price for the early investor is calculated using the cap, resulting in an effective price per share of $0.50 ($5 million / 10 million shares).

This means the early investor receives 200,000 shares ($100,000 investment / $0.50 per share), while a new Series A investor investing the same $100,000 would only receive 50,000 shares ($100,000 investment / $2.00 per share). The valuation cap effectively allows the early investor to acquire shares at a lower price, reflecting their earlier and riskier contribution.

Why Valuation Caps are Used

Valuation caps are included in early-stage investment agreements to address the inherent uncertainties of nascent companies and to balance the interests of both investors and founders. From an investor’s perspective, the cap protects against excessive dilution if the company experiences rapid growth and achieves a significantly higher valuation in its next funding round. It ensures that the early investor receives a share of the company at a price reflecting the early risk they undertook, rather than the potentially much higher valuation achieved later.

Founders, on the other hand, use valuation caps as a tool to attract crucial early capital without being forced to set a definitive, and potentially low, valuation for their company prematurely. By offering a valuation cap, founders can defer the complex valuation discussion until a later stage when the company has more traction and data to support a higher valuation. This flexibility helps founders secure necessary funding to advance their business development.

The cap functions as a mechanism for aligning expectations and sharing potential future upside. It offers investors the promise of a favorable conversion price if the company succeeds, while allowing founders to raise funds without immediately valuing their company at a fixed, potentially low, amount. This structure helps bridge the gap between early-stage risk and future potential, making investments in uncertain ventures more appealing to early backers.

Valuation Caps in Convertible Agreements

Valuation caps are most commonly found within convertible notes and Simple Agreements for Future Equity (SAFEs), which are popular instruments for early-stage startup funding. These agreements allow investors to provide capital now with the understanding that their investment will convert into equity at a later date, typically during a subsequent priced equity financing round.

Another common term often found alongside a valuation cap in convertible agreements is a discount rate. A discount rate allows the early investor to convert their investment into equity at a specified percentage discount to the price per share paid by new investors in the qualified financing round. For example, a 20% discount means the early investor pays 80% of the price per share that new investors pay. When both a valuation cap and a discount rate are present, the investor’s shares will convert based on whichever term provides the more favorable (lower) price per share at the time of conversion.

An example demonstrates this “better of” scenario. If an early investor has a convertible note with a $10 million valuation cap and a 20% discount, and the subsequent Series A round has a pre-money valuation of $20 million with a $2.00 per share price, two calculations occur. First, the cap conversion price would be $1.00 per share ($10 million cap / $20 million valuation $2.00 per share). Second, the discount conversion price would be $1.60 per share ($2.00 per share (1 – 0.20)). In this instance, the valuation cap provides the lower price per share ($1.00 versus $1.60), so the investor would convert their investment at the $1.00 per share price, receiving more shares.