Valuation caps protect holders of convertible bonds from situations where start-ups experience significant capital gains between the issuance of convertible bonds and the financing cycle that follows. If the company experiences huge valuation growth between seed financing and Series A round, holders of a convertible bond will receive only a very small percentage of the next round without an valuation ceiling. (See Scenario 1. Valuation caps and change discounts are mechanisms for convertible bonds to convert their debt positions into preferred capital in a lower corporate valuation than in the last financing cycle. From an investor`s perspective, higher valuations reflect more expensive investments, with investors having to pay more for the same level of ownership. A lower valuation means that convertible bondholders obtain shares at a more favourable interest rate than the current valuation. All startups are likely to seek financing at some point in their growth. Knowing what a convertible bond and a convertible bond ceiling (and why startups should try to avoid one, if possible) can be helpful for entrepreneurs when considering typical options for raising capital at the beginning of the period (see 3 most common seed financing alternatives – Weighing the pros and cons for more seed financing alternatives). There is a notable exception to this rule: the STANDARD SAFE form has no duration (which is also the reason why it is not called a loan). Therefore, “SAFE” holders cannot demand a conversion (or refund) until there is equity financing or sale of the business. On the other hand, the recent shift to a post-money ceiling helps investors in this regard, as it weakens the continuation of SAFEs/Convertibles financing for founders (see above).
This means that the investor will get the best of both opportunities. A lower conversion price per share means that the credit converts to more shares. The main advantage of issuing convertible bonds is that they do not require the issuer and investors to determine the value of the business if there is really not much on which an valuation could be based – in some cases, the business can only be an idea. This assessment is generally determined during Series A funding, when there are more data points from which an evaluation can be based. Investors will often negotiate the inclusion of a cap in a convertible bond, as it is the early investment of investors that has enabled the company to achieve the high pre-money valuation in the financing of Series A preferred shares, so they should benefit from the cap in the event of a significant increase in valuation between the issuance of the notes and the qualified financing. The above concerns do not mean that a cap on the basis of money should not be avoided under any circumstances. Indeed, it may be useful for the investor (lender) to be willing to offer a premium in return for the guarantee on the amount of his share in the conversion. But in this case, the founders should rely on the funding cycle that will be the source of the changeover to the euro. If there are doubts, particularly if equity financing requires a minimum size, the founders could better push to a cap before the money. In this case, subsequent convertible bonds, like the original convertible bond, are not included in the fully diluted capital, so the original lender is diluted by other convertible bonds as if it had provided “real” equity instead of the change.Back to Blog