Startups Cap Valuation & Conversion Discount — Does that Really Matter to the Founders or Investors?
Hello to all my readers..!
Startups investment is in itself a tricky task. The risk taken may not be the same for all the investors because early-stage/seed-stage investors are the ones who take more risk while backing these startups. That’s why it becomes crucial to incentivize them in the following successful round.
Cap valuation & conversion discount are the mechanisms that provide early-stage investors an option to convert their debt into equity shares at a lesser valuation in the following round.
Let’s understand how early-stage investors are incentivized or take care of the risk they take at early-stage investments with the help of an example:
Ms. J started her venture last year & received initial seed funding from Mr. X (Angel Investor) of $100K in convertible debtˆ without any valuation cap or discount. (ˆShe issued convertible debt, so no impact on the cap table for now)
We assumed that the company had issued 5 million shares, out of which 80% is with Ms. J & the rest is the ESOP pool. After the seed round, the shareholding of the company shall be as below (Shares in Million):
Let's assume Ms. J closes a series A round of $1 Mn this year at a pre-money valuation of $5 Mn. The new series A investor shall get 1 million shares [$1 Mn (investment)/$1 (share price)] — the share price is calculated as below:
*Share price: $1 = ($5 mn/5 mn shares) [Pre-money valuation/no. of outstanding shares)
Now, let's see how valuation cap & conversion discount impact the shareholding of the Angel investor (Mr. X) under different scenarios.
Case 1: Considering there is no discount & no cap to the valuation
In that case, Mr. X shall get 100k or 0.1 Mn shares ($100K/$1) — representing his holding at 2% in the company. Below is the updated cap table for reference:
Case 2: Assumed a valuation cap of $ 3 Mn
In that case, Mr. X's potential no. of shares shall not be calculated on a $5 Mn pre-money valuation, rather, it shall be based on a $ 3 Mn valuation because Mr. X had kept the valuation cap of $3 Mn while investing at the seed stage. By exercising the valuation cap option, the no. of shares to be received by Mr. X shall be 166.6K or 0.16 Mn ($100K/$0.6) — representing 2.7% holding in the company (~0.7% more than the previous case).
"The valuation cap protected Mr. X from the increased valuation. If there wasn't any cap, he would have received 0.1 Mn shares only instead of 0.16 Mn"
*Share price for Mr. AD $0.6 ($3 Mn/5 Mn) — Applied the share price formula
Case 3: Assumed a valuation cap of $ 7 Mn
In that case, Mr. X shall not have the advantage of cap & his share price shall be the same as case 1 (Share Price — $1). Accordingly, he will be allotted 0.1 Mn shares on conversion. So, no change in the shareholding.
Case 4: Assumed a Discount of 25% to the valuation
In that case, Mr. X’s potential no. of shares shall not be calculated on a $5 Mn pre-money valuation, rather, it shall be based on a $3.75 Mn valuation ($5 Mn less 25% discount — $3.75 Mn). By exercising the valuation cap option, the no. of shares to be received by Mr. X shall be 133.3K or 0.13 Mn ($100K/$0.75) — representing 2.17% holding in the company (~0.17% more than case 1).
*Share price for Mr. AD $0.75 ($3.75 Mn/5 Mn) — Applied the share price formula
Case 5: Assumed a Discount of 25% & Valuation cap of $ 3 Mn
In that case, Mr. X shall have the following options to choose:
We can see that option 2 ($3 Mn cap valuation) is best for Mr. X to opt. In that case, he will receive ~0.17 Mn shares representing 2.7% holding in the company.
Note: “Caps aren’t valuation” — It places a limit on the price at which the conversion will happen.
Founders at the early stage prefer to raise money via convertible debt because it takes less time & money to conclude the deal. However, they should be careful about accepting the deal with a lower cap valuation/higher discount because that may result in higher equity conversion for the investor in the following round. On the contrary, a conversion discount is the best option for Investors because that will always provide them a reduced share price relative to subsequent new Investors.
Thank you, friends. I hope this article has provided you with greater insight on valuation cap & conversion discount which are critical deciding factors for Investors & Founders. In my next blog, I will write about Pre-money & Post-money valuation. Till then, bye & take care!
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