How Does a Valuation Cap Protect Investors from Dilution?

One of the most significant issues for startups regarding financing is investors’ dilution protection. That involves early-stage funding of a startup’s seed and convertible note rounds. The result of dilution is that every time a company issues new shares, the ownership percentage of existing investors gets diluted.

The valuation cap protects against such risk. It prevents early investors, especially those who have invested in convertible notes or SAFE instruments, from being too diluted when new investors join at a higher valuation.

This article will explain how a valuation cap works and safeguards against diluting an investor’s share in a startup.

What is a Valuation Cap?

A valuation cap is a maximum price at which holders of convertible notes or SAFE can convert their investment into the company’s equity. Thus, it avoids dilution for early investors since the company’s valuation will increase further in subsequent funding rounds.

For better understanding, assume an investor is providing seed funding of $100,000 to a startup using a convertible note. The valuation cap is $5 million. However, the startup’s valuation increased to $10 million in its Series A funding round.

With no valuation cap: The investor automatically converts his $100,000 to the higher $10 million valuation, diluting his effective ownership percentage.

With a valuation cap: The investor converts his investment, assuming the company has a $5 million valuation.

How does the Valuation Cap Prevent Investor Dilution?

Investors funding early-stage startups are taking significant risks to do so. The valuation cap protects the early-stage investor from dilution; they receive equity at a lower predetermined price if the company’s value has appreciably increased when they convert their notes. That’s a much more significant ownership stake in appreciation for that early risk.

For instance, an investor who commits $200,000 to a company with a valuation cap of $5 million will hold 4% of the business if the same company’s valuation is at $5 million in that conversion period.

However, suppose the company’s valuation rises to $20 million by the next financing round. In that case, the cap serves to cap valuation and shield the investor from dilution. It saves them around 4% of their equity, rather than the 1% they would have received at that $20 million valuation if the entire investment had been in equity.

Aligns Investor and Founder Interests

A valuation cap establishes the fact that founders align themselves with early investors, who understand the risk that early investors are taking by offering protection against dilution in exchange for early support. This gives them an element of trust and cooperation, which helps them secure funding for seed and pre-seed rounds.

For example, Airbnb secured $600,000 from Sequoia Capital and Y Combinator in 2009 using a convertible note with a $1.5 million cap and a 20% discount. The investors would thus acquire shares at a maximum valuation of $1.5 million or a lower valuation than the following investment round.

This was a great bargain for Airbnb since it allowed them to raise money quickly and effortlessly without compromising too much equity or control. It also allowed them to demonstrate their traction and expansion before determining a value. At $7.2 million by the time they raised their Series A round in 2010, the convertible note holders received a 4.8x return on their investment.

Encourages Early-Stage Investment

Early funding helps startups to scale themselves more effectively. Valuation caps guarantee early investors that their equity will not be diluted too much by better performances and higher valuations from the company at a later stage. This motivates more investors to invest in the early rounds of funding that a startup requires to build and grow from scratch.

When funding a pre-seed company, investors might consider the valuation cap as an important factor as this will enable them to take up more equity shares and assure them of being part of the company at the later funding round.

Valuation Caps Driving Early-Stage Investments

Valuation caps motivate early-stage investment by giving clear-cut guidelines to investors and startups regarding the early phase. The caps avoid dilution of investors’ interests while putting enough money in the pockets of startups to sustain and grow. These caps make the terms fair and square during investment negotiations between parties in future funding rounds.

Eqvista provides comprehensive solutions to startups, including ease of managing valuation, funding rounds, and investor relations. Our equity issuance and tracking feature is invaluable for founders as they aim at growth while appropriately protecting the interests of the investor, which eventually helps navigate the complexities of early-stage funding.