How does a discount rate affect a valuation cap?

For convertible notes or SAFEs, the discount rate is the amount by which the share price in traditional equity financing is discounted.

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Early investors might be rewarded for taking a huge risk by structuring convertible notes and SAFEs with a discount. The discount entitles them to convert their investment at a lower price than what the following round’s equity investors will pay. The conversion valuation cap (or “cap”) is a new mechanism for rewarding early investors for the risk they take and, presumably, the efforts they make to help the firm grow in value.

Valuation cap and discount rates

The pre-money value of a firm is the valuation of the convertible debt round, which is usually a Series A funding round. A valuation cap is the maximum price at which an investor’s investment can be converted into shares. The discount rate is the interest rate charged by the Federal Reserve Bank on short-term loans to commercial banks and other financial institutions. The discount rate is the interest rate used in discounted cash flow (DCF) analysis to determine the present value of future cash flows.

What is the valuation cap?

A valuation cap is a limit on how much a SAFE can be converted to equity ownership in the future. It’s the maximum price at which an investor can convert a SAFE to stock: a predetermined amount that “caps” the conversion price once shares are issued. It’s usually computed by multiplying the Pre-Money Valuation by the amount of capital raised in a financing. The Post-Financing Fully Diluted Capitalization can also be determined by multiplying the share price of the stock sold in the financing by the share price of the stock sold in the financing.

Understanding convertible notes and SAFE

A convertible note is a type of short-term debt that converts to equity, usually combined with a future fundraising round; in essence, the investor is lending money to a startup. Instead of receiving principal plus interest, the investor receives shares in the company. The Scaled Agile Framework® (SAFe®) is an enterprise-scale collection of organizational and workflow principles for implementing agile methods. The framework is a body of knowledge that provides systematic instruction on roles and responsibilities, job planning and management, and upholding principles.

How does the valuation cap work?

The value cap is a means for seed-stage investors to be rewarded for taking on more risk. Your convertible security’s valuation cap determines the highest price at which it can be converted into equity. Multiply the value cap by the series A valuation to convert this to a share price. In a convertible note, a valuation cap is utilized to offer noteholders a “ceiling” value at which their investment will convert from a loan to equity. As a result, a “floor” in terms of their ownership.

What are discount rates?

A discount rate can refer to the Federal Reserve’s short-term loan interest rate or the rate used to discount future cash flows in discounted cash flow (DCF) analysis. The discount rate is the interest rate charged by the Federal Reserve Bank on short-term loans to commercial banks and other financial institutions.

How do discount rates work in convertible notes and SAFE?

The SAFE discount is derived by dividing the valuation cap by the typical equity financing valuation and then removing that value from one (representing no discount). In this case, $2 million / $4 million = 0.5 and 1 – 0.5 = 0.5 would be the mathematical representations.

Discounts often vary from 0% to 20%. Let’s imagine you have a 20% discount rate on a convertible note. If a venture investor invests $20 million in that company at $3 per share, your note converts to equity for $2.40 ($3.00 *.8) per share. It’s worth noting that discount rates are not fixed.

The effect of discounts on a valuation cap

For convertible notes or SAFEs, the discount rate is the amount by which the share price in traditional equity financing is discounted. The discount rate is frequently referred to as a “bonus rate” for investors who took a risk on investing in a company much earlier than other investors in a standard equity transaction.

Consider the following scenario: a convertible note or SAFE investor offers the company $1 million, and the convertible note or SAFE states that it will be subject to a 50% discount rate. This means that during a standard equity offering, the convertible note or SAFE would convert into shares of the company at a 50% discount to the price paid by other investors.

How does the valuation cap work with discount rates?

The discount is a percentage off in the next round, whereas the cap is a maximum cap on the next round’s valuation. If the cap is exceeded in the following round, early investors will not receive both a discount and additional shares. Either one or the other inventor receives a 20% discount and a $7 million maximum.

Understanding the effects of the discount rate on the valuation cap with deep analysis

One of the most frequently misunderstood aspects of discounted cash flow analysis is the discount rate. The sum of all future cash flows (C) over some holding term (N) is discounted back to the present using a rate of return in a discounted cash flow analysis (r). The discount rate (r) in the following formula is the rate of return.

Formula

The formula to calculate the discount rate is:

Discount % = (Discount/List Price) 100

The compound of the investment at a specific rate of interest when calculating the future value of money set aside today. The challenge of calculating the present value of future cash flows is one of discounting rather than growing, with the required projected return acting as the discount rate.

When it comes to discounted cash flow analysis, the discount rate you choose can greatly impact your valuation. It’s a little more challenging for a corporate investor to choose the right discount rate. When choosing a discount rate for financial decisions, corporations frequently use the Weighted Average Cost of Capital (WACC). A company’s assets are often financed through debt or equity. A company can also use retained earnings, which are earnings after taxes that are not given to shareholders as a dividend.

Scenario 1: $5m Pre-Money Valuation Cap, 20% Conversion Discount

The debt would convert at $0.50 per share under the valuation cap, which gives the least conversion price (and the greatest equity to the convertible debtholder). The examples in this article show how valuation caps and conversion discounts can affect a convertible debt holder’s interest in a company.

In actuality, the final cap table amounts would need to be changed to account for any accumulated convertible bond interest. Converting convertible debt to the preferred stock would also create additional liquidation preferences, further complicating the cap table in the event of a liquidation.

Scenario 2: No Valuation Cap, 20% Conversion Discount

Instead of a valuation cap, the convertible debt deal contains a 20% conversion discount. Instead of converting her shares at $1 per share, like in Scenario 1, the angel investor can convert them for $0.80 per share ($1 x (1-20 percent)).

The 20% conversion discount gives the convertible debtholder a larger share in the company than if there was no conversion discount or valuation cap in the agreement (Scenario 1).

The addition of a conversion discount ensures that, regardless of the valuation, the convertible debtholder will always obtain equity at a lower price than the most recent investors.

Scenario 3: $5m Pre-Money Valuation Cap, No Conversion Discount

Using the same facts as the other scenarios, the amount of stock distributed to all shareholders, excluding the angel investor, would stay unchanged. The presence of a valuation cap may affect the number of shares received by the angel investor upon conversion.

By dividing the valuation cap by the number of fully-diluted shares, the conversion ratio implied by the conversion cap is computed, yielding a value of $0.50 ($5m / 10m). The Series A investor, the founder, and the employees who participate in the stock option pool all suffer dilution due to the valuation cap.

The need to set the valuation cap at a fair and reasonable level is shown by these declines in ownership. If the cap level is set too low, founders may lose a large amount of value, investors may be hesitant to engage in the company, and workers may decide not to join the startup because their stock option programs are diluted too much.

Because convertible debt doesn’t always show up on the cap table until it’s converted, some founders may not know they have to offer these debtholders any ownership at all.

Scenario 4: No Valuation Cap, No Conversion Discount

Consider a startup that receives $2 million (m) in convertible debt seed capital from an angel investor. A year and a half later, the company raised $6 million in a Series A round, valued at $11 million pre-money.

The ownership structure of the startup just prior to the Series A financing is shown in the cap table, which includes 1 million shares designated for an employee stock option pool. Note that the convertible debt does not initially appear on the cap table because we do not know how many shares it will convert to.

After the Series A fundraising round, the angel investor only owns a small portion of the company. Despite the fact that the angel investor made a significant contribution to the startup’s development, it was not able to profit from it.

What is an uncapped note and how does it affect investors’ decisions?

Convertible notes are debt investments that feature a provision which allows the principal and interest to be converted into an equity investment at a later date. Convertible note financings are less expensive and faster to complete since they are easier to document from a legal standpoint.

Convertible notes avoid putting a number on a business, which might be advantageous, especially for seed-stage companies with insufficient operating history to establish a suitable valuation. If more equity rounds are not completed, the convertible note will become debt and will need to be redeemed, potentially forcing still-fragile businesses into bankruptcy.

To avoid the aforementioned, rules and conditions can be imposed that, if carried too far, contradict the goal of the convertible note and result in a time and effort investment comparable to a regular equity round.

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