What is a Valuation Cap?

What is a valuation cap? How can it affect stock ownership?

Valuation caps in convertible notes or simple agreements for future equity (SAFEs) (together, “Convertible Securities”) can set the price at which such Convertible Securities convert, and thus can greatly affect future financing rounds, dilution to existing equity holders and the ownership and capitalization of a company. This article explains the implications of a valuation cap for stock ownership and, in turn, later financings.

What is a valuation cap?

A valuation cap is a maximum value ascribed to the company, and it therefore dictates the highest price per share (PPS) that a Convertible Security holder will pay for shares when the Convertible Security converts at the time of a subsequent financing. Generally, with a valuation cap, Convertible Securities will convert based on the lower of the agreed-upon valuation cap or the company’s valuation at a subsequent financing.

Therefore, if a bridge investor negotiates a low cap and the company ends up with a very high valuation in its subsequent financing round, that bridge investor’s Convertible Securty will convert at a significantly lower PPS than the PPS paid by the subsequent financing round investors. This can result in the bridge investor having a higher ownership stake in the company than if such investor had invested cash in the equity financing.

How is a PPS calculated based on a valuation cap?

The PPS at which a Convertible Security converts into shares equals (i) the valuation cap, divided by (ii) the company’s capitalization. While the valuation cap and the definition of capitalization are agreed in connection with entering into the Convertible Security, the actual capitalization is not determined until the conversion of the Convertible Security. This means that if a company increases its capitalization (based on the agreed definition) between entering into a Convertible Security and the conversion of the Convertible Security, the PPS will decrease.

For example, if a company enters into a Convertible Security with a valuation cap of $3 million and the company has a capitalization of 500,000 shares at the time of entering into the Convertible Security – the company may anticipate that the Convertible Security will convert at a PPS of $0.60. However, if the company increases its capitalization to 600,000 before the Convertible Security converts into equity, the actual PPS would be $0.50.

This is important because, in many instances, the agreed definition of “capitalization” will include the shares reserved (but not issued) under a company’s incentive equity plan or any increase to a company’s equity incentive plan in connection with a financing. Therefore, an increase to the capitalization used to determine the PPS (and corresponding decrease to the PPS at which the Convertible Security converts into shares) may result from an increase to the shares reserved under the incentive equity plan even if those shares never end up being utilized or issued.

Because of this, companies should be cautious with overly excessive increases to their equity incentive plans while Convertible Securities are outstanding.

Why does this Matter?

The following example highlights what can happen with a low valuation cap.

GrowCo is a tech startup founded by Charlie, who is the only initial shareholder and holds 5 million shares of GrowCo’s common stock.

After one year of operating, Charlie needs more money to continue the company’s work, so the company enters into a convertible note with Skylar E (a bridge investor). Skylar E’s convertible note is worth $500,000, and she negotiates a valuation cap of $3 million. This means that, based on a capitalization of 5 million shares, the highest PPS at which Skylar E’s note will converts at a subsequent financing is $0.60 per share (calculated by dividing the $3 million valuation cap by the $500,000 amount of the note). GrowCo’s capitalization table after the note issuance is below.

GrowCo’s Pre-Series A Financing Capitalization Table

Stockholder	Common Shares
Charlie B	5,000,000

 

Convertible Note Holder	Valuation Cap	Note Amount	Maximum PPS at Conversion
Skylar E	$3,000,000	$500,000	$0.60

 

Two years after the bridge note, GrowCo has expanded rapidly and is preparing for its Series A financing round. GrowCo is now valued at $9 million, and the Series A investors (Fast Growing Fund, L.P., Strong Performance, L.P. and Next Level Investments, L.P.) each invest $1 million, for a total of $3 million. The Series A investor share calculations are below.

 

Series A Investor PPS	$1.80	GrowCo valuation ($9 million) divided by the number of shares outstanding prior to the Series A financing (5 million shares)
Each Series A Investor Shares	555,555	Amount invested by each investor ($1 million) divided by the Series A Investor PPS ($1.80)

 

At the time of the Series A financing, Skylar E’s note automatically converts into Series A shares. Because Skylar E’s valuation cap was $3 million, which is much lower than the $9 million valuation, she will only pay a PPS of $0.60 and will receive 833,333 Series A shares.

Skylar E’s valuation cap resulted in Skylar E receiving a 66% discount on the Series A PPS. A side-by-side comparison against a regular Series A investor, followed by GrowCo’s post-Series A capitalization table.

 

	Each Series A Investor	Skylar E
Series A PPS	$1.80	$0.60
Series A Shares	555,555	833,333

GrowCo's Post-Series A Financing Capitalization Table

Stockholder	Common Shares	Series A Shares
Charlie B	5,000,000
Fast Growing Fund, L.P.		555,555
Strong Performance, L.P.		555,555
Next Level Investments, L.P.		555,555
Skylar E		833,333

Additional Consideration: While the example above, assumes a 5 million pre-money capitalization in each example, in many instances the Series A investors may set their pre-money valuation of the company to include the shares issuable upon previously issued Convertible Securities, which results in a lower PPS for the new cash investors. So, the lower the valuation cap of the Convertible Security:

• the lower the PPS at which the Convertible Security will convert,
• the more shares that the holder of the Convertible Security will receive as a result of the conversion,
• the higher the pre-money capitalization (inclusive of the shares underlying the Convertible Security) will be for new cash investors,
• the lower the PPS of the new cash investment in the financing,
• the more shares that the new investors will receive for their investment, and
• the more dilution that the existing stockholder will face in the financing.

The takeaway

Valuation caps can create big discounts and can greatly, yet unintentionally, affect stockholder ownership of a company. In the scenario above, the valuation cap allowed Skylar E to acquire one and a half times as many Series A shares as each of the Series A investors, despite only investing half as much money. It is important to carefully understand valuation caps and the effects that such caps may have on existing stockholders and future rounds because valuation caps can have material consequences to the company’s capitalization and dilution that existing stockholders face in a financing.

DLA Piper is a global law firm operating through DLA Piper LLP (US) and affiliated entities. For further information please refer to www.dlapiper.com. Note past results are not guarantees of future results. Each matter is individual and will be decided on its own facts. Attorney Advertising. Copyright © 2025 DLA Piper LLP (US). All rights reserved.