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Valuation Cap

The NFX Team · @nfx · May 2021

Negotiate This

What are they?

The valuation cap is one of the most important aspects of a SAFE (Simple Agreement for Future Equity)  or convertible note term sheet. The valuation cap sets a ceiling for the price per share that the investment will convert to equity at and is a way to reward early-stage investors for the additional risk they’ve taken on.

Let’s look at an example: 

  • An angel invests $500K in a startup on a note with a $5M cap and no discount. 
  • The startup subsequently raises a $1M Series A at a $10M pre-money valuation and a price per share of $5

With the cap, the angel will get to convert their $500K at $2.50 per share ($5 x $5M Valuation Cap$10M New Valuation), whereas without the cap, they’d have to convert at the same $5 per share of the Series A investors. The valuation cap nets them twice as many shares as they would have gotten otherwise.

How They Appear In A Term Sheet

VC Perspective

VCs defacto assume that the valuation cap will be their post-money valuation, so the cap is determining their entry price (along with the amount raised). As a result, many VCs will be focus on this as a major part of the negotiation. 

Founder Perspective

  • Along with the discount rate and amount raised, valuation caps are one of the most important elements of a SAFE or convertible note term sheet. From the founder’s point of view, uncapped notes are preferable as the extra-equity investors earn from a valuation cap will come from the common  stockholders. Punitively low caps can make it harder for a startup to raise future funding. Most investors will require some form of cap.   For example, a Fenwick Survey showed that in 2010 83% of seed financing had a cap.
  • Also note that the bigger the round you raise at a cap, the more you’re diluting your own equity. So if you say raise $5mm at a $10mm cap, you’ve effectively given up 50% of the equity in a company vs. if you raise $2mm at $10mm cap, you’ve only given up $20% of the stock in your company. 

Legal Perspective

  • Valuation caps can be a useful tool to reward certain investors and show progression on the path to a larger priced round. This can happen by providing earlier or higher value investors a lower cap, which is effectively a better valuation
  • Valuation caps can become very dilutive when you get multiple notes stacked on top of each other at similar valuations, because the cap determines the post money, so everyone’s stock position gets diluted by new stock issuances without a step up in share price. 

The NFX Take

Valuations are probably the single most important term after the amount raised in a term sheet negotiation.

This along with company performance will determine the price and dilution of the investment round.


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