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What is a Valuation Cap?
Investing in the earlier financing rounds is risky. As a reward for that risk, company’s typically include investor preferential terms such as valuation caps and discounts when issuing convertible promissory notes. A valuation cap sets the maximum valuation at which the investor’s loan would convert into shares. This protects the investor from converting into a very small equity stake in the event a next equity financing occurs at a very high pre-money valuation (i.e., value of the company prior to the Series A investment).
As an example, a company may agree to a $4,000,000 valuation cap in exchange for a $25,000 convertible note investment. This $25,000 would remain debt of the company until the next equity financing (e.g., Series A round). At the time of the Series A closing, the original convertible promissory note holder would convert based on a pre-money valuation (i.e., value of the company prior to the Series A investment) of $4,000,000 in the event the Series A pre-money valuation is higher than $4,000,000.