How does a Valuation Cap work on a safe note?

How does a Valuation Cap work on a safe note?

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Hey, it's Scott Orn at Kruze Consulting. And today I'm answering the question, how does a valuation cap work in a SAFE note?

And this is a super common question I get. SAFE notes are meant to be quick, easy, and inexpensive financing documents. And they're typically done by angel investors, or seed investors with a very early stage startup. And so you might hear a founder going around saying "Hey, I'm raising $3 million on a $15 million cap SAFE note." And so what that means is they're raising $3 million of capital and the cap or the embedded valuation is effectively $15 million.

And the difference between a SAFE note and like a preferred equity valuation, a round, is that the SAFE note is really relying on that cap to be the valuation instrument or determine what the valuation is. Whereas in a preferred stock purchase agreement there's a very clear price per share that the investors are paying and you know the total shares out in the company. And so therefore you multiply the shares times the price per share, and you get the total valuation of the company.

But again, SAFEs are meant to be fast, easy and cheap. Preferred valuations are just a little, take a little bit longer, more negotiation a little more expensive. So SAFEs are very common. So, in that example with the $3 million raise on a $15 million cap if all goes well, the SAFE note is closed. and then nine months later the Series A is raised at a much higher valuation. Then the early investors in that SAFE note are basically gonna own 20% of the company, 3 million goes into 15, it's 20%. And they get that lower valuation than what the Series A investors are paying because they took the risk and invested in the startup early.

But it is nice that they had a cap on that note so they knew they were always gonna get 20% if things went right. There's an alternative, which are uncapped notes. Uncapped notes are super duper founder friendly and it basically means you don't know what valuation you're eventually investing into if you're an investor. The founders will take the money, they'll invest it, build value in the business and you are forced to convert at whatever the next round is. So that Series A, when that comes in, you're basically gonna get the same valuation as the Series A investors even though you invested a lot earlier. So you can imagine this is not something that investors love to do but if the company is hot enough, they can sometimes do it.

Now, there's one little digression an uncapped note will typically almost always have a discount to the next round. So you're looking at 15 to 20% discount. I'll explain that in another video but you'll basically get a slightly better deal than those series they investors, but the smart angels, the smart seed funds, if they're gonna do a SAFE note they're always gonna ask to have a cap in that note. So they pretty much know what valuation they're investing in. And again, they can do the simple math, whatever they're investing the amount of money they're gonna bank that a percentage of the cap and know their valuation.

So again, $3 million raise on a $15 million cap. The investors are effectively buying 20% of the company. The cap is just a really fancy way of having an embedded valuation in the deal. I know it's confusing. Hope this video helps. We'll have a bunch more on this topic 'cause it is something that people ask for all the time. Hope that helps. Thanks.