How Misunderstanding a Startup’s ‘Valuation Cap’ Can Get Expensive

  • 10.22.2015

NOTE: This article by former Counsel John Demeter originally appeared on The Experts blog on on August 28, 2015.

California may be suffering through a drought, but Silicon Valley is being deluged—with venture-capital funding. VC money continues to pour into in the country’s tech hub and beyond. VCs invested $13.5 billion in the first quarter of 2015, the fifth consecutive quarter that investments topped $10 billion, according to PricewaterhouseCoopers LLP and the National Venture Capital Association’s MoneyTree report.

If you’re a founder who’s raking in a share of that bonanza, congratulations. You’ll want to make sure your excitement as you scoop up that funding doesn’t cloud your judgment. Understanding terms you’re agreeing to in a convertible note financing is especially critical. Should your take off like Facebook or WhatsApp, that lack of clarity can have material implications for ownership and control—and cost you millions of dollars down the line.

Entrepreneurs and investors often discuss a “valuation cap” when they’re negotiating convertible notes or convertible securities. But the parties may have different understandings of how that cap works. Surprisingly, there’s no standard language used industrywide to guide parties as they draft and the underlying convertible instruments that include a “valuation cap.” To avoid any surprises down the line, all parties should understand the ramifications of the wording in their and investment documents.

One Example, Two Outcomes

Let’s take look at an example with two different outcomes: Amy, Brad and Charles each invest $1 million in a promising (yet completely fictional) , Yoga-a-go-go, a yoga studio on wheels.

These three believers are the business’s earliest investors. In for putting up early money, they want both upside and downside protection. That includes a “valuation cap”—a pre-negotiated valuation of the company at which their investment converts into the company’s next equity financing (such as Series A ) should the company’s valuation dramatically increase between now and then.

The investors and Yoga-a-go-go’s founders sign a that includes a $10 million valuation cap upon conversion of the convertible note.

Yoga-a-go-go’s founders assume that the $10 million valuation cap is a cap on the pre-money valuation of Yoga-a-go-go. They expect that if the investors’ $3 million converts at the valuation cap, it will be invested on top of the $10 million valuation cap, resulting in a $13 million total post-money valuation. The group of investors would then each own 7.6%, or 23% of the business collectively.

The trio of investors has a different understanding. They assume the $10 million valuation cap includes their $3 million investment, giving them each 10% ownership of a company valued at $10 million, post investment. Collectively, they’d own a guaranteed fixed percentage—30%—of Yoga-a-go-go.

So who’s right?

They both are. Both positions and interpretations are completely legitimate. The misunderstanding stems from whether the “valuation cap” was a cap on the pre-money valuation (what the company was worth before the new investment) or a valuation that included the new round of investment.

Defining a Valuation Cap

Is this even a big deal? Many founders would say no. They’re busy running a and don’t want to spend the time and money to consult a lawyer. Budget-conscious founders are often happy to have their investors’ legal team draw up the and definitive investment documents.

But remember that investors fare better with a valuation cap that includes their investment, ensuring them a fixed ownership percentage. If the says only “$10 million valuation cap,” then it will be to the investors’ advantage to draft documents that further define the valuation cap to their benefit.

Returning to our example, you might wonder whether it matters that Amy’s ownership percentage of Yoga-a-go-go is 7.6% or 10%. The 2.4% difference is probably insignificant now. But when Yoga-a-go-go makes the cover of Entrepreneur magazine and begins franchising, that difference in ownership percentage can have a big impact on Amy’s profit and the founders’ control.

The best way to avoid misunderstandings down the line is to talk upfront with your investors about what valuation cap means to them—and to you. And always your attorney to review your with you. It won’t take more than an hour or two to clarify any ambiguous terms and explore the long-term implications of a valuation cap.

While a disagreement on the meaning of terms is unlikely to lead to litigation, it can damage a productive investor relationship. It’s better for all parties in a deal to be clear on what they’re getting and what they’re giving up. That’s the best way to prevent a few sentences today from costing you millions later.