The term "cap" refers to a valuation cap. Convertible Notes and SAFE investments either have a valuation cap or they are "uncapped."
A "valuation cap" sets the maximum price that your convertible security will convert into equity. It entitles investors to convert the outstanding balance on the note into shares of stock at whichever is lower: the valuation cap or the price per share in a qualified financing. It is intended to ensure that an investor does not miss out on significant appreciation of a company between the time of the sale of convertible notes and the qualified financing.
- You invest in a startup at Seed stage using a convertible note with a cap of $5M
- Series A investors decide startup is worth $10M and pay $1/share
- Your note will convert into equity as if the price had actually been $5M– meaning your effective price is $0.50/share ($10M divided by $5M).
- You ultimately receive twice as many shares as the Series A investors for the same price.