A valuation cap is the maximum value of the company at which the investor’s investment can convert into shares. This protects the investor’s investment in that, if the company is valued at more than the cap at the time of conversion, the investor will receive a number of shares based on calculations that use the cap as a substitute for the company’s actual valuation. Essentially, it enables them to receive more shares in exchange for their investment than they might otherwise if the company is valued at more than expected (eg if its shares become worth more).
Different valuation caps can be set for the conversion to shares due to different events. For example, a valuation cap may be set for conversions:
immediately before the completion of a qualifying funding round
immediately prior to an insolvency event
in the event of an exit by the company (eg if the company is sold or made public (ie listed on a stock exchange))
on the longstop date
A valuation cap for an exit or insolvency event, and often for conversion on a longstop date, should generally reflect a more realistic (ie less optimistic) valuation of the company. This is typically lower than the valuation cap set for a funding round.
Valuation caps are included in Advance Subscription Agreements to ensure that the existing shareholders have some certainty as to the level to which their shareholding will be diluted on conversion (based on how many shares are likely to be issued to the investor). Valuation caps also ensure that an investor does not end up with an unexpectedly low-value shareholding if the company is successful in achieving a high valuation at the next funding round or in certain other events (eg insolvency).