Valuation Cap
A valuation cap is a mechanism commonly used in convertible securities, such as a SAFE (Simple Agreement for Future Equity) or ASA (Advance Subscription Agreement), to establish a maximum price at which the security can convert into equity in future funding rounds. It serves as a protection for investors by placing a limit on the conversion price, ensuring that their investment is not diluted excessively in case the company's valuation increases significantly before the conversion event.
When the conversion of a convertible security takes place, usually during a subsequent equity financing round, the valuation cap comes into play. If the valuation of the company in that round is below the valuation cap specified in the convertible security, the conversion price will be determined based on the lower valuation. This means that investors with the convertible securities will receive a larger number of shares for their investment, as the conversion price is capped at a more favourable rate.
The purpose of a valuation cap is to provide investors with a measure of downside protection and to prevent excessive dilution of their ownership stake in the company. It allows investors to benefit from the growth of the company while ensuring that their initial investment is not significantly diluted if the company's value increases substantially before the conversion event. The valuation cap is typically negotiated between the company and the investors during the investment agreement process and serves as an important component in determining the potential returns for the investors in the future.
