This content is for educational purposes only and should not be considered tax, financial, or legal advice.
Most early-stage founders consider two types of securities to receive investment:
the convertible note (and its siblings: SAFE, KISS, and other notes);
and equity-based investment, typically via preferred stock, AKA “priced round”.
One of the main differences is the application of a valuation cap vs. a valuation.
A valuation cap is:
Used for convertible notes and other non-equity investments.
An estimated amount (i.e. $4M), representing the value of the company at some point between issue and the time of the next priced round.
The estimated amount is the result of a negotiation with the (lead) investor. Often, it favors the investor for the valuation cap to represent the company’s current value, and it favors the founders for it to represent the value of the company at the time of the priced round.
A per-share price is not established and the company is protected from a true down round. Note: this does not protect the company from facing a down round if it has established a per-share price in a previous round.
A valuation is:
Used for equity-based investments.
A precise dollar amount representing the current value of the company, and its per-share stock price.
Typically represents the value of the company before receiving the incoming investment, AKA “pre-money”. This value is the product of significant analysis, due diligence, and negotiation between the lead investor and the company.
Creates the possibility of a future “down round”: the scenario of issuing stock at a lower price than a previous round, i.e. your first priced round is issued at $1/share and 12 months later you issue a new class of stock at $0.50/share.
It’s often recommended that founders wait to value their company until they’re generating significant revenues via repeatable sales and marketing operations.
In practice, however, it’s rarely that simple. The decision to raise a priced round should be based on investor interest, financing plan and raise volume, traction and competitive considerations, and many other factors.
Successful early-stage founders often prioritize bringing on great capital partners who will support the company long-term, over focusing too much on valuation or valuation cap in a single round.
Note that this article only considers investment for US corporations.
Greenprint Growth Partners LLC is a boutique consulting firm specializing in corporate development for early-stage companies and investors.