A valuation cap is the maximum valuation at which a SAFE or convertible note converts into equity, protecting investors from dilution if the startup achieves a very high valuation in the next round.
A valuation cap does not prohibit a company’s valuation from exceeding a threshold, but it limits the amount that can be used in determining the conversion of notes to stock.
Doing so prevents early investors from receiving a smaller percentage of the company in exchange for their investment. It also acts as an incentive for investors to fund early, inherently risky businesses.
In the context of Simple Agreement for Future Equity (SAFE) notes, a valuation cap guarantees that the investor will receive shares in the company at a rate that does not exceed the valuation cap (or at a lower valuation in the case of the next funding round) will be done. (The assessed value is lower than the upper limit.)
Example of upper limit of evaluation
If a startup issues a no-discount SAFE with a valuation cap of $10 million, and the next round’s valuation is $20 million, the investor will receive up to $10 million in equity. If the next round’s valuation is his $5 million, the investor receives shares at her $5 million valuation.
If this same scenario includes a 20% discount rate and the company ends up being valued at $10 million, the SAFE investor would buy the stock at a discount equal to 20% of the stock price. You will have to do so.
Benefits of upper evaluation limits
SAFEs often include valuation caps to provide investors with downside protection and encourage them to invest in the company at an earlier stage. Without a valuation cap, investors run the risk of investing in a company that achieves a very high valuation in the next round of funding and are unable to participate in that valuation increase.
Both investors and companies need to work together to increase the company’s valuation over the long term, and the upper limit of valuation is set when a rapid increase in valuation occurs in the early stages of the company. It provides protection for early stage investors in case of
Overall, valuation caps are important terms to consider when issuing a SAFE, as they can have a significant impact on an investor’s return on investment and a company’s dilution.
It is important for both startups and investors to carefully consider the appropriate valuation cap for SAFEs based on the company’s current growth stage, future growth prospects, and market conditions.