The second key term is valuation cap. A valuation cap is a ceiling or cap on the valuation of the company.
It means the holders of the convertible notes or SAFEs will have a limit or ceiling on how high the company valuation will go before their investment is converted into equity. This sounds a little counterintuitive. You'd think they would want the company valuation to be as high as possible, but it does give them a benefit. This valuation cap occurs even if the other new investors who only turning up in the price round if they agreed to and pay a higher price per share based on a higher valuation. This effectively acts as a price ceiling. The new investors may have to pay the high price, but the older convertible note or safe investors pay a lower capped price. Very nice indeed. For the early stage investors, this ensures that the seed investors get a certain percentage share of a company in the conversion, and it can prevent an excessively high valuation from squeezing their percentage share lower and lower and lower for the seed investor. While some company startups may be able to negotiate an uncapped convertible note or SAFE, which would be preferable for the current shareholders, i.e.the founders, a valuation cap is one of the most appealing aspects for seed investors. It gives them a reward if the company valuation starts to shoot up and is a reward to them for the risk of investing early in the company's life. For example, our early stage VC investor may have invested a $100,000 in an unpriced round convertible note or SAFE, but with a valuation cap of $800,000 attached to it. What this means is that in a future funding ground, this equity stake of a $100,00 will get part of the company, which cannot be valued higher than 800,000 for those investors holding this convertible node or safe. So if they convert, the equity they get will be equivalent to one eighth of the company. We can see here the next funding round has established a company valuation of $1.5 million, which is higher than the valuation cap. Thus, the early stage investor would exercise the convertible note or SAFE, and have their equity investment converted at a valuation cap of 800,000 equivalent to one eighth of the company. Value. The investment of a hundred thousand dollars Would now be valued at $187,500, one eighth of the 1.5 million valuation. Now, if the next funding round was valued at lower than 800,000, this note would not be exercised as the lower valuation would be unattractive for the investor. They would prefer to keep their convertible notes or SAFE. But now let's compare to new investors, not the early stage investors holding the convertible note or the safe. New investors would not have access to this attractive low valuation.
A new investor putting a hundred thousand dollars into the company would only gain ownership of one fifteenth of the company as it has been valued. At 1.5 million $100,000 would only allow them to purchase one fifteenth of the company. So both the discount rates and the valuation cap act as bonus shares issued to the seed stage investors as a reward for taking higher risks that came with investing so early. If a convertible security has both a discount rates and a valuation cap, the investor typically gets to exercise the option that gives them the lowest conversion price per share. I.e., they get to choose the option that is most advantageous to them. This can be determined once the trigger event. Usually an upcoming price round takes place.
