I’ve heard many entrepreneurs claim their startup to be worth $X million, based on the “valuation cap” [Note the bold, underlined, italicized text!] they received in a recent convertible note financing. Don’t make this mistake!
Take a minute to consider how the valuation cap works. In a typical convertible note, investors convert into shares of preferred stock at the lower of (1) a discount to the price paid by preferred stock investors (typically 20%), and (2) the valuation cap. So your valuation cap is really the HIGHEST price a noteholder can possibly pay upon conversion. If I say “the most I’d ever pay for your sh*tty car is $1,000,” your car isn’t suddenly worth $1,000. I simply don’t think it’s worth a penny more than that.
But who cares?! I promise I wouldn’t be wasting your time if it didn’t matter.
When a startup issues stock or options to employees, the stock/options must be issued at their fair market value. So, if you think your startup is worth your valuation cap, you may want to issue stockholder equity at that valuation. This mistake unnecessarily lowers the incentive and retention effect of your equity compensation. If an employee has to pay thousands of dollars to purchase their stock, why stick around to earn it? Lucky for you, you’ve read this blog post and will never base your startup’s value on its cap.