Valuation Cap & Equity Conversion Explained


Valuation Caps are often thought of as the Value of the startup. However, Valuation Caps are NOT the value of the company and the conversion of SAFEs and Convertible notes into equity is a little tricky.

If you’ve had the pleasure of reading or maybe even using a SAFE or a Convertible Note (both referred to as “Convertible Vehicles”) you’ll know that they have a Valuation Cap. And if you got that far into the excitement of it all, you’re probably trying to figure out how these convertible vehicles convert to equity.

The Basic Premise

You'll note that "conversion" is a commonly used term here and it refers to the fact that neither SAFEs nor Convertible Notes start as equity. 

They are designed to convert to equity at a later date when the value of the startup can be determined more clearly. The conversion and valuation cap is described here. 

Valuation Cap and Why It's Not the Value

The Maximum Value

Valuation Caps are the implied MAXIMUM that the investor and founder agree is the value of the company.

Why is that even a distinction you might think? Well, it’s important because the investor can get a lower price than the valuation cap when the convertible vehicle converts to equity. 

If you’ve read up on SAFEs and Convertible Notes, you’ll know that neither of them are equity, until they convert to equity

The Down Round Protection

At the conversion, the convertible vehicles will convert into equity at a valuation no higher than the valuation cap.

But if the value comes in below the Valuation Cap (what is referred to as a “down round”) then both SAFEs and Convertible Notes will convert at the lower value.

This way the investor ensures the best price. 

What Does the Conversion Process Look Like?

There are two steps to the conversion process. 
  1. The mechanical step is where you calculate the shares and ownership stake and 
  2. The legal where lawyers draw up the legal docs and issue actual stock to the investors. 

Doing it Right

This should go without saying, but I’ve worked with enough startups to know that it actually needs to be said. Anything that concerns equity, transfers of equity, or investment rounds needs to be carefully documented by legal counsel. If you don’t have a lawyer, I’m sorry to say you’ll need one and it’ll be expensive. 

The Conversion Trigger

What Is It?

In nearly every case, another financing round triggers the conversion of these convertible vehicles into equity. Financing rounds are often named as “Pre-Seed”, “Seed”, “Series A, B,C” etc. 

The names don’t mean much, they’re not standardized and many people refer to them differently. 

What matters; however, is whether the financing round is a “priced round”. 

Sometimes you will have other pre-negotiated instances that trigger conversion, but for the sake of ease, we're only going to focus on the standard.

Priced Round

The financing round that triggers conversion is “priced round” because that’s the first time when the company’s value is determined by a cohort of investors (i.e. market). 

The legal documents refer to this financing round as a “Qualified Financing” or something similar. The definition for a qualified financing round varies - sometimes it’s a specific dollar amount and sometimes it's more vague than that. 

For the sake of ease, just think of a “Qualified Financing” and “Priced Round” as the same and know that it usually implies that it has to be “large enough to matter”.


What Does the Math Look Like?

The math to calculate the conversion is very simple. The hard part is gathering the variables required in the equation. 

Shares Issued = (Investment + Accrued Interest) / Conversion Price


The Equation Variables


Investment = The amount of money the Investor contributed with a SAFE. This number should be stated in the legal document and equate to the amount of cash you received.

Accrued Interest = Only Applies if there's an interest rate, usually on a convertible note. This is the amount of interest that has accumulated. 

Conversion Price = The lower of the SAFE Price and Share Price Paid by Investors in the Priced Round

SAFE Price = Valuation Cap / Capitalization of the Company

Valuation Cap = Described above and will be found in the legal documents

Capitalization of the Company = All Shares Issued + All Shares Authorized Under the Stock Option Plan + All other promised shares

All shares issued = the shares issued outside of the stock option plan, usually that includes founders, advisors, and anyone else who has been formally issued shares but not under the umbrella of the stock option plan which is counted separately

All Shares Authorized Under the Employee Stock Option Plan (“ESOP”) = Most companies will have an ESOP, especially modern startups. If you don’t, you can enter zero for this, but your investors will likely require you to get one to ensure you can attract talent. You want to count every share authorized, not just the ones already granted to employees because the assumption is that eventually all the shares authorized will be allocated to employees. You can find this number in your ESOP documents. 

Think of the Capitalization as the sum of all shares of the company. The point here is to account for everyone in the company, including all the shares that are reserved for future employees under your stock option plan, if you have one. By doing this, you ensure that you’re accounting for the entire ownership of the company when you run the calculations.

All other promised shares = any shares that you may have promised but have yet to issue that wasn’t counted above. This is a catch all for all the other promised shares to ensure that the entire ownership of the company is represented.

Share Price paid by Investors in the Funding Round = this is the price that the new investors are paying for shares in the new funding round. Unless, it’s a “down round” where the value is below the valuation cap, you will likely not use this number as it will be higher than the SAFE price and the equation requires the lower of the two.