Valuation Cap: What is it, and what does it mean?

150 150 Abe Wehbi

By Abe Wehbi
abe@jayaramlaw.com

One of the most common terms a Founder will hear during fund raising is “Valuation Cap.” Valuation caps are one of the most negotiated terms of any round of financing, so, getting familiar with that is it and what it means for your Company.

To start, it is important to understand that a Valuation Cap IS NOT the current valuation of your Company. Instead, a Valuation Cap is the maximum price set for conversions of the convertible debt. This, essentially, allows investors to utilize the upside of their investment, as they would have in a straight equity investment.

Okay, so what does this mean for your Company? The Valuation Cap only comes into play if the triggering event sparking conversion of the convertible debt is at a valuation that exceeds the cap. In this event, the investors will receive equity at the cap value, as opposed to the value of the Company at the trigging event. In turn, this means that the effective discounts the investors receive on the share price increases.

Let’s now put this into play. If, for example, the investor is offered an initial discount of 15%, and the convertible debt instrument contains a Valuation Cap of $4,000,000, but the Company is valued at $5,000,000 at such time. In this event, the investment would convert at the Valuation Cap amount, providing the investor with a 20% discount (both the discount and the difference in valuation).

The interplay between Valuation Caps and Discounts is fairly complex. Maintaining accurate accounting of your Company’s value at the time of seeking investment, and know where your Company will be valued at the time the funds are received, can help alleviate some of this complexity.

 

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