Valuation Cap

What is a valuation cap?

Valuation cap (Bewertungsobergrenze) describes, in a convertible loan or a comparable convertible instrument, the highest company valuation that is applied when the invested capital is converted into shares. The short form is cap; in the US market, the cap appears above all in SAFEs and convertible notes. However high the next funding round is valued, the investor converts at most at the price per share that results from the cap. The effect resembles a maximum price on a pre-order: if the price rises before delivery, the early buyer still pays no more than agreed.

The cap is set out in the agreement on a convertible loan or a SAFE and is negotiated between the company, its founders and the early investors. It takes effect above all in the qualified financing round, often also as the conversion valuation at the end of the term or on a company sale. Alongside the conversion discount (discount), a percentage reduction on the round price, it is one of the two economic levers of a convertible instrument. It determines the minimum stake an early investor in a startup receives if the company develops well.

How it works: from valuation cap to conversion price

For conversion, the cap is translated into a price per share. The cap price is the valuation cap divided by the number of shares that the agreement fixes as the reference base. This is usually the shares before the round on a fully diluted basis (all business shares including the shares from employee programmes), without the conversion shares themselves. Opposite the cap price stands the discount price, that is, the round's price per share after deducting the agreed conversion discount. Conversion takes place at the lower of the two prices.

Formula: cap price = valuation cap / shares of the reference base; conversion price = lower of cap price and round price × (1 minus discount); conversion shares = conversion amount from loan and interest / conversion price

From this rule follows a threshold. The cap becomes effective only when the discount price lies above the cap price. With a 20% discount, this is the case as soon as the round price exceeds the cap price divided by 0.8, that is, 1.25 times it. If round and cap use the same share base, this corresponds to a round valuation of 125% of the cap. Below the threshold, the discount alone determines the price, above it the cap alone.

Reference base: pre-money cap or post-money cap

The cap price depends on which shares go into the base. If the cap is worded as a valuation before the round on a fully diluted basis, the allocated and unallocated virtual shares regularly count alongside the business shares. Without an express provision, it remains open whether an increase of the pool decided in the round and other convertible instruments count too. The more positions the base comprises, the lower the cap price and the more conversion shares arise; the dilution from these positions is then borne by the other shareholders.

In the US market, for SAFE agreements, the cap after conversion has been common since 2018 (post-money cap). The investor's stake before the new round capital then corresponds exactly to its amount divided by the cap, and additional convertible instruments are borne solely by the existing shareholders. Arithmetically, this corresponds to the approach for the post-money valuation. In German convertible loans, the wording as a valuation before the round is common, but both forms occur.

Negotiating a valuation cap: level and signalling effect

The cap is not a valuation, but acts like an anchor. Investors of the follow-on round see at what price early investors came in and derive expectations from it. A low cap gives early-stage investors, if things go well, a large discount against the round and dilutes the founders accordingly. A very high cap hardly protects the investors and can raise expectations for the next valuation that the market does not confirm.

Convertible instruments without a cap, with a discount only, occur mainly when the next round is foreseeable in time and existing investors finance the time until then. If the cap price of an interim round (bridge round) lies below the price per share of the last round, the cap works economically like a down round. It can then also affect the anti-dilution protection of earlier investors, that is, their claim to compensating shares on issues at a lower price, depending on how the clause treats conversions.

Valuation cap in a Series A and a company sale

In a Series A, the cap determines how many shares the conversion generates. Because the conversion shares are often included in the share count before the round, a low cap usually does not change the new investor's stake. Rather, it lowers the effective pre-money valuation, that is, the value that arithmetically falls on the shares of the existing shareholders.

If a company sale occurs before conversion, many agreements provide for conversion at the cap immediately before closing, alternatively repayment with a premium. The cap thereby determines the investor's share in the sale proceeds to which the investor is entitled after any liquidation preferences have been satisfied.

Worked example: calculating conversion with valuation cap and discount

The capital of a GmbH (German limited liability company) comprises 40,000 shares on a fully diluted basis. A convertible loan with a conversion amount of EUR 450,000 including interest converts in a qualified round. A discount of 20% and a valuation cap of EUR 6 million before the round, based on these 40,000 shares, are agreed.

• Cap price: EUR 6,000,000 / 40,000 shares = EUR 150
• Threshold: 150 / 0.8 = EUR 187.50 round price, corresponding to EUR 7.5 million on 40,000 shares
• Round at EUR 150 per share: discount price 150 × 0.8 = EUR 120, thus below EUR 150; conversion shares 450,000 / 120 = 3,750
• Round at EUR 250 per share: discount price 250 × 0.8 = EUR 200, thus above EUR 150; conversion shares 450,000 / 150 = 3,000
• Effect of the cap at EUR 250: with the discount alone 450,000 / 200 = 2,250 shares, with the cap 750 shares more; value of the 3,000 shares at the round price 3,000 × 250 = EUR 750,000, effective discount 1 minus 150 / 250 = 40%
• Lender's stake before the new round capital: 3,000 / 43,000 = about 6.98%; with a post-money cap of EUR 6 million it would be 450,000 / 6,000,000 = 7.5%

In a round at EUR 150, that is, exactly at the level of the cap, the discount remains decisive, and the lender receives more shares than in the more highly valued round. The cap limits the price per share upwards, not the number of shares.

Distinction: valuation cap, pre-money valuation, floor and preference cap

• Pre-money valuation: the negotiated valuation of the company before a round. The cap, by contrast, is only a maximum value for the conversion price of a single instrument.
• Valuation floor: the less frequently agreed counterpart. It limits the conversion price downwards and protects the founders against conversion at very low prices.
• Cap on a liquidation preference: also often called a cap. It limits the total proceeds of an investor who, alongside the preference, also participates in the remaining proceeds, not a conversion price.

Common mistakes

• Cap read as a valuation. Anyone who understands the cap as an agreed valuation carries it unchecked into the negotiation of the next round.
• Reference base left open. Without a determination of whether the pool, a pool increase and other convertible instruments count towards the base, the same agreement can be calculated with different share numbers.
• Before and after the round confused. A post-money cap leads, at the same figure, to more conversion shares than a cap before the round.
• No link to the achievable valuation. If the cap lies far below the realistic round valuation, a large discount results; if it lies far above, it has no protective effect and sets a high anchor.
• Several caps without an overall calculation. Loans with different caps convert at different prices; their combined effect is shown only by a pro forma cap table.
• Sale case not regulated. If there is no rule for a sale before conversion, it is open whether the cap also determines the share of the proceeds there.

Frequently asked questions

Is the valuation cap the valuation of the company?

No. It is a maximum value for the conversion price of a particular instrument. The valuation of the next round is negotiated independently of it and can be above or below it.

What happens if the round is valued below the cap?

Then the cap has no effect. The investor converts at the round price less the agreed discount or, if no discount is agreed, at the round price itself. With a 20% discount, this applies up to a round valuation of 125% of the cap, assuming the same share base.

What is the difference between valuation cap and discount?

The discount is a percentage reduction on the round price and applies at every round valuation. The valuation cap caps the price and takes effect only above the threshold. If an agreement contains both, they are not cumulated: the lower of the two prices applies; an additional discount on the cap price would have to be agreed expressly.

Can the cap be changed afterwards?

Only by agreement with the investors, with several lenders often with the majority fixed in the agreement. In practice, this happens mainly on an extension of the term (maturity date), for which lenders often demand a lower cap.

What is a customary cap?

There is no universally valid figure. The yardsticks are the valuation realistically expected for the next round and the risk that the investor bears by coming in early. As a rule of thumb, the cap price lies above the price per share of the last round, otherwise the cap acts like a down round. At the same time, it tends to stay below the valuation expected for the next round, so that it actually protects the early investor.

The Roemer Capital view

For every valuation cap, we first clarify which share count it refers to and whether it applies before or after conversion. We then run the conversion through in the financial model for a base case, a cautious case and an optimistic case of the next round valuation. This makes visible at what round price the cap takes effect and how many shares it costs the founders.

In Series A processes, we also take into account that investors read a low cap from earlier convertible loans as an anchor. The equity story, the presentation of the company's development and prospects to investors, must then explain what has changed in the company since the cap was agreed.