What’s the main purpose for a valuation cap on a convertible note? Good, bad, ugly? by @R44D
Answer by Raad Ahmed:
As stated previously convertible notes are designed to convert into equity of the issuing company upon a subsequent financing. Without a cap the notes would typically convert into the issuing company’s equity in the subsequent financing at the same price as the equity issued in that financing. A “valuation cap” entitles note holders to convert into equity at the lower of the valuation cap or the price in the subsequent financing.
One of the main benefits of the cap for convertible note holders as Gil Silberman accurately notes is that it avoids an unfair discount in the future if the company undergoes additional financing or is sold.
From the perspective of the startup the valuation cap must be negotiated which adds further expense and time and given the prevailing stance (and a very logical stance) among investor’s valuation caps are an unavoidable provision in convertible note deals.
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