What is a valuation cap, and how does it work?

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A valuation cap is the highest valuation at which a SAFE or convertible note will convert into shares, whatever price the priced round actually sets. If an investor holds a SAFE with a $5 million cap and the Series A values the company at $20 million, the investor converts as though the company were worth $5 million and gets four times the shares their money would buy at the round price. The cap exists because SAFEs and notes were meant to postpone the valuation, and once companies started raising their first priced round late, at high valuations, postponing it left the earliest investors with a sliver. The cap is a ceiling on that outcome, and it has become so standard that most people treat it as the valuation of the seed round. Post-money caps, which is what you will be offered Almost every SAFE written today uses a post-money valuation cap, and many notes have followed. A post-money cap fixes the investor's ownership directly: investment divided by cap. $500,000 at a $10 million post-money cap is 5 percent of the company immediately before the priced round, however many other SAFEs the company sells, because each is calculated as if it were the only one. That is the version to model, because it means the cap is not really a valuation at all. It is a percentage, and every dollar you raise under it comes out of the founders' share. A pre-money cap, the older form, divides the cap by the shares outstanding before the round and lets the SAFEs dilute each other, which is why the two forms give different answers for the same numbers. Cap against discount An instrument with both a cap and a discount converts at whichever gives the investor the lower price. The discount matters in a round priced below the cap; the cap matters in a round priced above it. A $5 million cap with a 20 percent discount is a discount in a $6 million round and a cap in a $20 million one. Investors usually care more about the cap, because the cap is what protects them when the company does well. The liquidation preference problem There is a side effect founders miss. Converting investors receive the same series of preferred stock the new investors buy, with the same per-share liquidation preference, having paid much less per share for it. An investor who put in $500,000 and converts at a third of the round price holds shares carrying a $1.5 million preference, which is what they would be paid first in a sale. Some rounds fix this by converting the cap or discount shares into a separate shadow series of preferred with a preference equal to the money actually invested, or into common stock. Ask for it. The same problem is a reason a priced Series Seed round, where every investor's preference equals their check, can be the cleaner answer once the raise is large enough. Where to set the cap is a business question about how much you are raising, what the next round is likely to price at, and what percentage you can afford to give away before it. The size of the raise and the cap magnify each other, so model both together before agreeing either.

What is a valuation cap, and how does it work?

Post-money caps, which is what you will be offered

Cap against discount

The liquidation preference problem

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