Convertible Note Cap
In short, the “cap” in the convertible note is the maximum price at which the debt of the investors would convert into the equity in the next round of equity financing.
A convertible note cap is a limit for the maximum valuation at which the funding made to the company through the convertible note can convert into the equity.
The debt of the investor would convert at a lower value of the next qualified priced round and the cap. In short, the “cap” in the convertible note is the maximum price at which the debt of the investors would convert into the equity in the next round of equity financing.
For instance, in case an investor purchases $20,000 of a company’s convertible debt, and the company becomes very successful with the next equity round at a valuation of $200,000, the investor would only be able to convert their debt into 10% of the company’s shares. However, if the convertible note had a convertible cap of $100,000 on it, even if the company’s value significantly increases to $200,000 at the next round, the investor would be guaranteed to convert their note at the lower value of $100,000, thus increasing their shareholdings after conversion to 20%.
Hence, when a “cap” is placed on the convertible note, the investor is insured that they would not own less than 20% of the company when the next equity round is there. In case there is no cap, and the next round has a high valuation, the investor could be indefinitely diluted.
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