Convertible Note and Valuation Cap Explained

A convertible loan agreement is essentially a future contract, or, more specifically, a call option merged with a loan agreement, which gives the lender the right to convert the loan into equity (shares of a company).  

The basic components of this agreement are generally the same:

- Loan Amount: Funding amount, the loan or debt amount.

- Interest Rate: The holder of the convertible note earns interest on the note, the interest, which accrues throughout the term, gets added into the total value of the note when converted to shares.

- Discount rate: The note holder gets a discount on the stock price, which will be established using the future funding round (The discount is generally between 15% and 30%).

- Conversion trigger: a defined trigger that converts the note into equity (this is usually the startup’s next round of funding).

- Valuation Cap: the maximum value set for your company at which the note will convert.

Convertible notes are considered to be a more suitable funding source for early-stage startups, in addition to personal funds, funding from family and friends, and crowdfunding.  For startup founders, a convertible note can be used as a bridge to the next level, where they’ll be better prepared for potential VC funds.

Investors accept a high level of risk when investing in early-stage startups, and thus require a decent return on their investment. Convertible notes thus reward investors by granting them interest on the loaned amount. In addition, investors will gain the maximum amount of shares possible in return for their investment value by applying a discount on the price per share or using the valuation cap.

How to calculate valuation cap?

One of the most important components of the convertible note is the valuation cap, which can substantially affect the equity ownership of co-founders and investors.

At Startup Falcon, we believe the best way to calculate the valuation cap is by using a valuation range, which is calculated by running several valuation scenarios and accounting for expected future achievements each time. Our valuation calculator allows you to run multiple valuations almost instantly — just start by filling out a valuation form. 

Using the Startup Falcon calculator is simple: 

• For your first valuation, make sure your inputs are compatible with your current achievement status— consider this the minimum for your valuation range.

• For your max valuation/valuation cap, make sure your inputs match inputs should match your optimal scenario in the next two to three years. 

Startup Falcon’s Valuation Cap Multiplier:

We’re also able to calculate your startup’s valuation cap using our own database, which gives us access to various valuation scenarios of comparable startups within similar data points and frameworks. This mechanism has performed iterations over the data points and set the standard for startup communities for future valuations based on multiples of current valuations. For example, it was able to conclude that, for any given startup, the valuation cap is 2.75 multiples of the current valuation, with an uncertainty interval of ±%5. 

Valuation Cap Numerical Example:

Pre-Money Valuation using Startup Falcon Valuation Calculator: $3,600,000

Current Valuation * Valuation Cap Multiplier = Max Valuation

$3,600,000 * 2.75 = $9,900,000

Calculate your Valuation Cap