SAFE is an agreement used by startups mainly to raise funds during their seed financing rounds. By using a SAFE, investors invest capital in the company, which converts into equity upon certain trigger events, most commonly a subsequent financing round.
A SAFE could contain investor-“friendly” economic mechanisms, such as discount and valuation cap, the first (discount) is used to describe the benefit of the investor as compensation for advancing funds to the company, and the latter, both for that purpose, but then also – to hedge the risk for potentially hyper-increase in a company’s valuation. For instance, if these terms are not available, capital invested by the SAFE holder will convert into equity at the price of the company’s valuation in the financing round.
This would not reward the early investor, and thus valuation cap comes to the rescue. In simple terms, it can be defined as a pre-negotiated figure that acts as a ceiling on the conversion price once shares are issued. As already mentioned, this is an important mechanism to negotiate, and thus requires proper understanding and special attention. This article focuses on analyzing the working of the valuation cap and explaining its purpose, and it will help you better understand the concept of valuation cap.
As already discussed, a valuation cap is one of the ways to calculate the conversion price per share in SAFE agreements, which implies the maximum price the investor would pay for each share upon conversion of the SAFE. The valuation cap helps determine the maximum price at which the convertible security will convert into equity. The conversion usually occurs at the lower of the valuation cap or the current valuation at the funding round.
If the company’s valuation exceeds the valuation cap in the subsequent “priced funding round” (i.e. when the share price is determined by a third-party investor), the SAFE holder’s capital converts into equity based on the cap, taking into consideration how the SAFE “calculates” the cap-based share price. On the other hand, if the company’s valuation is lower than the cap, the capital converts into equity at the priced valuation, which reflects no benefit to the investor, for advancing funds to the company.
For example, a SAFE holder invests a certain amount with a $ 5 Million valuation cap. But during the Series A financing round, the company was valued at $ 10 Million. As a result of the valuation cap clause, despite the new $ 10 Million valuation, the amount invested by the SAFE holder will convert into equity at the $5 million valuation cap. Thus, it helps provide SAFE holders with a better price per share than new investors.
Valuation cap also acts as a hedge against the high valuation. If the valuation increases significantly, then this clause would act and it will help set a reasonable valuation for the safe holders. This mechanism ensures that the investors do not miss out even if the company’s projected value increases compared to the previously negotiated estimate in SAFE.
Thus, an investor who anticipates a substantial valuation increase would favor this mechanism over a discount mechanism, because it serves as a realistic hedge against the value of the priced round’s share price, and protects its interest and prevents its investment from watering down even if the company’s valuation indeed increases drastically. For the same reason, startup founders also use this clause to attract investors because it allows for an added advantage to the early investors for taking on risks.
Also, the discount clause works in tandem with the valuation cap, but both cannot be used simultaneously under the new post-money v.1.1 SAFE. The investor and the company can agree on using one of the following SAFEs, YC currently provides (but of course previous versions are still available online) (i) the share price at the subsequent funding round; (ii) the valuation cap conversion price; and (iii) the price per share determined based on the discount.
From the above discussion, the importance of the valuation cap is very much evident. Investors could benefit a lot from using the valuation cap mechanism when a substantial value increase is anticipated, and thus they should pay special attention while negotiating the same.
At the same time, this clause can be used by companies to attract investors during the early-stage funding rounds, when valuation is not clear, but a substantial increase is something that is reasonable to expect when the company reaches a priced financing round. Both investors and founders must be cautious of the consequences of the valuation cap and choose a valuation cap that does not dilute their benefits afterwards.
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