Understanding Conversion Caps
Why Conversion Caps are not the same as a company valuation and only act as investor insurance.
Throughout a startup's lifecycle, and founders seek to raise external investor capital, it is more likely than not that they will issue some form of convertible security (e.g. "convertibles"); these include SAFEs (Simple Agreements for Future Equity), convertible debentures, etc. Multiple parameters differentiate one convertible from another, but throughout my years in venture, I've seen one of the seemingly most common-sense ones repeatedly cause confusion: the conversion valuation cap (or "conversion cap,” for short), especially as it pertains to how these compare to valuations set by equity financing.
Since each financing has lasting consequences for companies and their founders, it's crucial for founders to understand what valuation caps are, how they differ from equity financing valuations, and the purpose they serve.
What is a Conversion Cap?
A conversion cap is a mechanism used in convertible instruments to set a maximum valuation at which the convertible security will convert into equity.
Let's take a step back and recap the concept of Conversion Mechanics. When it is time for a convertible to finally convert into equity, often during a future financing round (typically referred to as a "Significant Financing" (or "SF") in the convertible security), one must determine how many shares the holder of said convertible is to receive (i.e., "Conversion Shares" or "CS"), which necessitates the determination of a Conversion Price per Share (i.e., the "CPpS"). The methodology for deriving the CPpS, which is defined in the convertible, is colloquially referred to as the convertible security's "Conversion Mechanics."
By far, the two most common mechanisms used to define a convertible instrument's Conversion Mechanics
Conversion Discounts: a percentage discount (most often 20%) to the price paid by the SF's investors; this produces the "Discount Price per Share" or "DPpS".
Conversion Caps: a maximum valuation at which the convertible security will convert into equity; when divided by the number of shares outstanding before the SF, produces "Conversion Cap Price per Share" or "CCPpS.”
Here's a typical example of how a convertible security will define its Conversion Mechanics
“Conversion Price” means:
for conversion in connection with Significant Financing, an amount equal to the lesser of (i) the Discount Rate multiplied by the lowest cash purchase price per share paid by investors in the Significant Financing and (ii) the Valuation Cap divided by the number of shares of the Company outstanding immediately before such Significant Financing (calculated on a fully diluted, as-converted basis).
Here, "Discount Rate" refers to 1 - the discount percentage (typically "1-20% = 80%").
The key phrase here is "the lesser of." It doesn't matter if the valuation cap is $12M, $15M, $20M, or even higher if the Significant Financing values the company @ $10M: the convertible is converting at a 20% discount to the new money's valuation. The Conversion Cap's purpose is to serve as a maximum (ergo "cap") valuation at which the convertible will convert into equity. In other words, the Cap is akin to Investor Insurance, and the convertible, no matter what the Significant Financing ends up looking like, will not have an effective pre-money valuation above said cap.
Conversion Cap vs. Equity Financing Valuation
One of the primary misconceptions I've seen surrounding convertible securities is thinking of/viewing the cap on a convertible as analogous to the valuation set during an equity financing round. I attribute this type of confusion to a failure to appreciate the psychological differences between an investor issuing a term sheet for an equity financing with an $X pre-money valuation vs. for a convertible with financing with $X conversion cap.
Pre-money valuation = (New Money Invested/FDO% Acquired) - New Money Invested
Conclusion
For tech startup founders, understanding the distinction between conversion valuation caps and equity financing valuations is essential. The cap is not an indication of the company's current worth but rather a protective measure for early investors. By viewing the cap as "investor insurance," founders can better appreciate its role in attracting and safeguarding early investments, ultimately contributing to the company's growth and success.
By understanding these concepts, tech startup founders can make more informed decisions about their financing strategies and build stronger relationships with their investors.
