Convertible debt is a core financing instrument within the technology ecosystem. The concept is straightforward: debt may convert into equity under predefined terms. Among the key features of convertible debt, valuation caps and floors have a significant impact on post-conversion ownership structure.
What Is a Valuation Cap in Convertible Debt?
A valuation cap sets the maximum company valuation at which the convertible debt will convert into equity. This mechanism rewards early investors who took on risk or backed the company before it gained traction, allowing them to receive shares at a lower valuation than the next equity financing round — thereby increasing their ownership percentage.
For example, if a convertible note includes a €10 million cap and the next financing round values the company at €20 million, the debt will convert based on the €10 million valuation. As a result, the investor receives more shares than they would at the €20 million valuation, increasing their stake in the company.
Valuation caps protect early-stage investors from dilution in high-growth scenarios. They incentivise seed-stage funding by guaranteeing a minimum ownership percentage, even in the event of rapidly rising valuations.
Valuation Cap vs. Discount Rate: Understanding the Difference
Understanding the distinction between a valuation cap and a discount rate is strategic. Both are incentive mechanisms designed to reward investors taking early-stage risk, but they function differently.
A valuation cap establishes a maximum valuation at which the debt converts into equity. Practically, this gives investors the right to purchase shares at the lower of the cap or the actual valuation of the round — a significant advantage in high-growth contexts.
By contrast, a discount rate provides a percentage reduction on the price per share in the next funding round. For example, a 20% discount means that if the next round is priced at €10 per share, the investor converts at €8 per share.
Many convertible instruments include both a cap and a discount. In these cases, the investor typically converts based on the most favorable terms — whichever provides the lowest price per share. For this reason, fund managers must carefully model both mechanisms to assess the dilutive impact of convertible debt on the cap table.
How Does a Valuation Floor Work?
A valuation floor defines the minimum company valuation at which convertible debt will convert into equity. It serves as a protection mechanism for founders and management, particularly in down-round scenarios, by ensuring that the debt does not convert at a valuation lower than the agreed floor if the company's valuation drops below a certain threshold.
For example, if the floor is set at €8 million and the new funding round is priced at €6 million, the debt will still convert at the €8 million valuation. This helps management avoid excessive dilution.
Key Benefits of Valuation Floors
Valuation floors act as protective clauses in convertible instruments, particularly during market downturns or when companies raise capital below expectations. These provisions are often added to protect founder equity and preserve governance stability. This is especially important in venture markets where valuations can fluctuate significantly.
How ScaleX Invest Simplifies Convertible Debt Management?
Centralised and Configurable Valuation
ScaleX Invest provides a dedicated module for convertible debt valuation, allowing all contractual terms to be centralized — including nominal value, interest rate, cap and floor clauses, maturity, and non-conversion terms. The platform supports standardizsed modeling scenarios, such as conversion at fair equity value, at an expected pre-money valuation, or repayment at maturity, instantly generating performance indicators such as fair value, IRR, and MOIC.
NAV Integration
Each convertible note is directly linked to the portfolio's Net Asset Value (NAV). The potential dilutive impact is modelled in real time, allowing for precise evaluation of its effect on fund performance and ownership distribution.
Cap Table and Waterfall Modelling
The platform includes an advanced modelling engine that projects the impact of convertibles on exit scenarios (M&A, IPO, secondaries) and cap table evolution. Distributions are visualised based on conversion mechanics, liquidation preferences, and distribution waterfalls.
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FAQs
1. What’s the difference between a valuation cap and a discount rate?
A cap sets a maximum valuation for conversion. A discount applies a reduction to the share price in the next funding round. The investor typically benefits from the more favorable of the two mechanisms.
2. Can a convertible note include both a cap and a floor?
Yes, many convertible notes include both a maximum and a minimum valuation for conversion.
3. How do valuation floors affect investor performance?
Floors reduce dilution risk for founders and existing shareholders. At the same time, they limit upside potential for convertible debt investors by capping the maximum equity stake they can acquire.
4. Are valuation floors included in all convertible notes?
Not necessarily. Floors are more common in venture capital deals due to the volatility of valuations.
