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What is a Valuation Cap? 

A valuation cap is a term used in convertible note financing that sets the maximum conversion price for the note, giving early investors the advantage of converting their investment into equity at a lower valuation if the company’s future valuation exceeds the cap. This mechanism protects early investors by ensuring they receive a favorable equity position relative to later investors.

How It Works:

• Issuance: A startup issues convertible notes with a valuation cap to early investors.
• Conversion: During a future equity financing round, the notes convert into equity at the lower of the valuation cap or the actual valuation.
• Example: If a startup issues a note with a $5 million cap and later raises funds at a $10 million valuation, noteholders convert their investment based on the $5 million cap.

Advantages: 

Valuation caps provide protection and potential upside to early investors by ensuring they receive a more favorable conversion rate. This can make convertible notes more attractive and align the interests of founders and investors.

Disadvantages: 

For founders, valuation caps can lead to greater dilution of ownership if the company’s valuation significantly exceeds the cap during future funding rounds.

Example: 

In 2004, Google used convertible notes with a valuation cap in its early funding rounds. Early investors benefitted by converting their notes at a favorable valuation when Google’s actual valuation soared during its IPO, ensuring substantial returns and a more significant equity stake compared to later investors.

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