Your Valuation Cap Might Be Giving Away Too Much Equity
When startups raise capital, they typically choose between two vehicles: a priced round or a note (Convertible or SAFE). A priced round is straightforward—investors know what they’re buying and how much it costs. It’s priced. Transparent. Low ambiguity.
A note, however, is a deferred bet. Investors don’t know what they’re buying until later—if and when a priced round happens. Because of that uncertainty, note holders get a special discount. Think of it as a risk premium. That discount usually comes in two forms:
A straight discount (e.g., 20% off the future share price)
A valuation cap (which may or may not result in a discount)
Convertible notes can also carry interest, but for now, let’s focus on the mechanics that most impact your equity: discounts and caps.
How Discounts Work
Let’s say your note includes a 20% discount. If your future priced round sets a share price of $10, note holders convert at $8/share. Simple math.
Valuation caps are a bit trickier. If the priced round’s valuation is higher than the cap, note holders convert at a price that reflects the cap—often resulting in a bigger discount than the flat rate.
Important: investors don’t stack discounts. If your note includes a discount rate and a valuation cap, investors will get whichever gives them the better deal. That’s usually spelled out in the note (as well as whether the future valuation is based on pre-money vs. post-money matters here).
Let’s Walk Through Some Scenarios
Imagine your note has a 20% discount and your priced round sets a share price of $10.
Scenario 1: Your company is valued at $5M, and the valuation cap is $7.5M. Since the cap is higher than the valuation, it’s ignored. The 20% discount applies, so note holders pay $8/share while priced round investors pay $10.
Scenario 2: Valuation and cap are both $7.5M. Again, the cap doesn’t create a discount, so the 20% discount applies. Note holders pay $8/share.
Scenario 3: Valuation is $9.375M, and the cap is $7.5M. The cap is 20% lower than the valuation, which matches the flat discount. It’s a wash—note holders still pay $8/share.
Scenario 4: Valuation is $10M, and the cap is $7.5M. Now the cap is 25% lower than the valuation, which beats the flat discount. Note holders pay $7.50/share.
And Then There’s Scenario 5: The Facepalm
You set your valuation cap at $2.5M—what you believe the company is worth today. Eighteen months later, your priced round comes in at $10M. That $10 stock? You’re selling it to note holders for $2.50.
Translation: you raised $500K and gave away $2M worth of equity. That’s not dilution—that’s a donation.
The Real Lesson
Investors want the lowest cap possible. It gives them the biggest discount. Founders—especially first-timers—often anchor the cap to today’s valuation. But the cap isn’t a mirror. It’s a bet. It should reflect what the company might be worth when the note converts, not what it’s worth today.
You’re allowed to assert that. You’re allowed to forecast growth. You’re allowed to protect your future equity.
Valuation caps aren’t just a technical detail—they’re a strategic decision. And if you’re not careful, they can quietly erode your ownership. So before you sign that note, ask yourself: are you pricing the risk, or just giving away the upside?