Essay About Rationale Of Valuation Cap And Valuation Of The Firm

Valuation Cap
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The rationale of valuation cap is to compensate the investors if the firm is doing well. There are the divergent interests of the traditional convertible note investor and the entrepreneur in the period prior to the Series A investment. The entrepreneur is using the money from the seed round to raise the valuation of the firm. If the discount rate for the seed investor is 20% and the valuation of the firm increased by 30% (if the seed investor owns the 50% of the firm) the percentage of the ownership of the seed investor will be diluted from 50% to 48%. So the higher increase in firm valuation will lead to low dilution of the entrepreneur. In this case, the advice or help provided by the investors will actually hurt them by diluting their ownership if it leads to a higher valuation of the firm. So the seed investors are taking the downside risk, but they are not compensated enough if the firm is doing well. That’s why they use the valuation cap to compensate if the firm raises a much higher valuation. The investors will convert the investment to the lower price between the following options. The two options are 1) at the discount price of the next round’s valuation and 2) at the discount price of the valuation cap. Favorable for the investorThe investors tend to set the valuation cap low while the entrepreneur wants to set the valuation cap as high as possible. The lower valuation cap can make sure that they are adequately compensated when the firm is valued higher. The higher valuation cap can ensure the entrepreneur doesn’t experience a serious dilution of the ownership percentage. Post-money valuation is the critical factor that decides the ownership percentage owned by the seed investors. With the increase in the post-money valuation, the investors are experiencing a decreasing ownership percentage until the post-money valuation reaches the cap valuation. When the post-money valuation is higher than the cap valuation, the investors’ ownership percentage won’t be further diluted. Using the same example in the “Convertible Notes in Seed Financings” notes for EAS545 to illustrate the favorable condition for the investor to have the valuation cap: In scenario 2 with $20M post-money valuation, the valuation cap is $5/share, which means the highest price that the investor will pay for the stock is $5. Based on the calculation of the notes, the discount price of next round valuation is $15.0625*0.8 = $12.05. If the investors are taking this price to convert their investment, the amount of share they can get is $750,000/$12.05 = 62240 shares. The total number of shares is $20,000,000/$15.0625 = 1,327,800 shares. The percentage ownership of the seed investor is 62240/1,327,800 = 4.7%. If the investors are taking the valuation price, the amount of share they can get is $750,000/$5 = 150,000 shares. The percentage ownership of the seed investor is 150,000/1,327,800 = 11.3%. It is clear that the investors are better rewarded with the valuation cap. So the investors want to set the cap as low as possible to ensure their return at the meantime, they are also happy to see the raising in the firm valuation since it won’t affect their ownership anymore.