Valuation caps on convertible notes
Whether a company should agree to a valuation cap in a convertible note will depend on its particular circumstances. From the company’s perspective, it is better to exclude a valuation cap, because it offers the investor down-side protection but has no benefit to the company. However, it may not be possible to exclude the cap if the investors condition their investment on including a cap and the company needs the money to fund its operations. Before making a decision, a company should consider the pros and cons of agreeing to a valuation cap.
There are downsides to a “cap” from the company’s perspective. First, it can result in an investor effectively paying a fraction of the full price for shares issued in the equity financing. In the example above, the convertible note holder received a share worth $1.00 but only paid $0.50, so the resulting from the was twice that resulting from the new money invested in the financing round. Second, not only does this result in more dilution, it also results in more preference. In the example above, the convertible note holder invested $100,000 and received 200,000 shares with a