Understanding The Valuation Cap

When a startup is just beginning, the founder or founders often do not have much money, if any, to invest in the business themselves. This means they must rely on investors to invest, often rather heavily, to get the business off the ground. However, investors want to put their money into things that are tried and true, such as businesses that already turn a profit or can easily show that it will not take long to do so. So what is a founder to do when they need investors but the business has nothing to offer in exchange for the investor’s money? They offer the investors a way to eventually own shares in the business. To sweeten the deal and convince investors it is worth the risk, startup founders will often put a valuation cap on these offers to eventually own shares. What are valuation caps, though? Are there any alternatives to them? How are they determined and what mistakes should founders watch out for when negotiating them? At Harrison Law, PLLC, our Arizona business attorneys are familiar with the process of getting a startup business off the ground. Call us at (480) 320-2310 to schedule a consultation to learn more about how you can get early investors and what valuation caps can do for your fledgling business.

What Is a Valuation Cap?

A valuation cap is a predetermined limit on the maximum valuation of a company. What does that mean, though? Businesses that have existed for a while can be valued based on an analysis of their assets, liabilities, financial statements and other factors. These things indicate the business’s value, or how much it is worth. In other words, if the business were being sold, the valuation indicates how much it could be sold for.

A startup seeking early investors does not have a valuation like this, however. What they have is the promise that one day, the business will hopefully be worth a certain amount of money. So they may offer the potential investors a valuation cap. This is the highest valuation at which the amount of money the investor gave the startup through a Convertible Security (described by Investor.gov as a security that can be converted to another type of security, such as preferred stock converted to common stock) or Simple Agreement for Future Equity (SAFE) would be converted into shares. In other words, this is the maximum valuation the investor will pay for shares, regardless of the actual valuation of the future equity financing.

A Valuation Cap Example

Early investors invested in an Arizona startup with Convertible Securities and SAFEs that had a $10 million valuation cap. When the startup does the next round of financing, new investors are investing at a $20 million valuation. The early investors that have the Convertible Securities and SAFEs with a $10 million valuation cap will pay half of what the new investors pay for the same number of shares. If the new investors were investing at a $30 million valuation, the early investors would only pay one-third of what the new investors pay, and so on.

The $10 million valuation cap was the promise that the investors would never pay more than that, even if the company were worth far more. This allows the early investors, who took a bigger risk by investing in a company that had no evidence it would be successful, to benefit from the success of the business.

What Benefits Does a Valuation Cap Offer?

A valuation cap offers benefits to both the startup’s founders and its investors. Understanding these benefits is important for founders to be able to negotiate fair valuation caps and persuade early investors to take the risk on the startup. Investors should understand the benefits so that they know why investing early is worth the risk.

Founders

Obviously, the biggest benefit to founders is that they get the money they need to start and grow their business. By providing valuation caps, they offer investors a deal that allows them to potentially see significant return on their investment. Because investors want to see the biggest return possible on their investment, a valuation cap allows investors to analyze and estimate the various returns they may see, encouraging them to invest.

Another benefit for founders is the ability to avoid needing a business valuation. Getting a loan from a bank and other financing options often requires being able to provide a business valuation or otherwise prove that the business is viable. While startup founders are hopeful about the viability of their idea, they often have no clear proof yet. Valuation caps allow them to give investors something tangible for their investment without having to guess at how well their business might do. Additionally, valuation caps protect founders against diluting their ownership stake by selling too much equity too early.

Investors

A valuation cap rewards early investors for taking a risk by investing in the startup. Valuation caps tell early investors that for the money they invest now, they may see a return of two, three, four, or many more times that investment without doing anything else. Without these preferential terms, the notes would convert into preferred stock at the same pricing terms that new investors are paying. This would mean there is no benefit for early investors to make that investment, as they do not know if the business will be worth anything at all.

Valuation caps also protect investors from overpaying if it turns out that a company is not worth as much as they think. This also prevents disputes over ownership later, by clarifying how much equity each party owns in the company before any funding occurs.

Negotiating a Fair Valuation Cap

Valuation caps benefit both founders and investors, but they tend to have a bigger advantage for investors. However, both parties must be willing to negotiate a fair valuation cap so that neither party feels taken advantage of. This negotiation can be done with a few simple steps. Harrison Law, PLLC may be able to assist your startup with investment negotiations.

Conduct Thorough Market Research

While getting a valuation for the startup itself may not be feasible, founders can do thorough market research into the valuations similar startups have gotten when they are further into the business life cycle. Founders should also conduct research to ensure they understand current trends in their own and similar industries. By doing so, founders can establish realistic valuation ranges and back up their negotiation position by providing data.

Additionally, founders may want to consider subscribing to newsletters and other sources of information on startup funding. Even if they also sift through information that is not as relevant to their particular circumstances, they may learn more that helps them understand their financing needs, valuation caps, and negotiating with investors.

Develop Strong Relationships With Investors

Investors know they are taking a risk with their money. However, they still want to minimize this risk as much as possible. One way they do this is by investing in startups with founders they trust. This trust is built by those founders being transparent about the challenges they have faced so far and ones they anticipate in the future, and providing regular progress updates about how things are proceeding. Being honest about any past business failures and the lessons learned from them can also help build trust when shared appropriately.

Demonstrate Traction and Growth Potential

Early investors are investing when the startup is still new and may not have a long, proven track record to show that the investment is solid. However, startups can still demonstrate traction and growth potential to encourage investors to take the risk.

Some of the simpler ways they may do this include:

• Developing Strong Products or Services: Even if the product or service is not available for sale yet, developing a strong product or service and demonstrating the need for it in the marketplace can be persuasive.
• Securing Customers: A clear record of sales, even if it is short, can be good proof that an investment is less risky. However, other options include having a waiting list of potential customers who have signed up to purchase the product or service once it becomes available.
• Demonstrating Your Ability to Scale: Small businesses are just as valid as large corporations, but they can be too small. If there is no ability to scale the business, investors may be less inclined to invest. Founders can create a plan that shows where they see the ability to scale.
• Generating Revenue: One of the most positive and influential ways to demonstrate traction and growth potential is by generating revenue. If the startup is already making money, investors can see that it has the potential to do so and will be more eager to invest, knowing that the startup is already succeeding and thus, more likely to give them a good return.

Consider the Company’s Stage and Progress

The startup’s development stage and current progress can tell investors a lot. Investors will look at the startup’s number of clients, revenue base, product or service maturity level, and current traction. These factors can indicate how much someone would pay to buy the startup right now. Typically, early-stage startups will have a lower valuation cap while more established startups will have a higher one. However, higher and lower valuation caps will also be relative to the size of the startup and its financing needs.

Consider Investor Interest and Competition From Other Startups

Founders should consider how much investor interest they have seen and how much competition there is from other startups for investment opportunities. If there has been significant investor interest or there are favorable market conditions, startups might be able to set a higher valuation cap. However, if there is limited investor interest or competition is high, startups may want to set lower rates to encourage investors to choose them.

Analyze Growth Plans and Key Milestones

The current value of a startup will change when certain key milestones are met in the startup’s growth plans. Founders should analyze the impact they expect those growth plans and milestones to have on the startup’s value. They should then consider a realistic valuation cap that keeps these milestones in mind.

Think About Future Financing Needs and Subsequent Investing Rounds

Startups may require several rounds of funding as they develop the product or service, validate market fit, scale their operations, and ultimately start turning a profit. Founders will want to keep these future financing needs and subsequent investing rounds in mind as they try to determine valuation caps. They will want to create a limit that considers future investors and leads to smooth transitions and no unnecessary breakages during these future investing rounds.

Seek Professional Advice

Many entrepreneurs have multiple business ideas and therefore, may have more extensive experience in negotiating investment terms. However, every startup is different. For founders who have little to no experience, advice from an advisor or business startup attorney may help to ensure they receive fair terms. Founders moving into a different industry or working with partners may also benefit from seeking professional advice.

Common Mistakes to Avoid When Negotiating a Valuation Cap

While there may be many potential mistakes that can be made while negotiating a valuation cap, there are some that are more common than others. These are the mistakes to be particularly aware of.

Overvaluing the Company

Startups want to aim high, but they should be cautious not to aim too high in their valuing of the company. Overvaluing the company can lead to unrealistic investor expectations. Additionally, it can lead to potential trouble with future financing, making it more difficult to attract new investors or secure future funding rounds. With each subsequent round of funding, it is essential for the startup to show an increase in valuation. Overvaluing the company early on can make this incredibly difficult. Pre-Seed investors may be persuaded to give the startup a high valuation, but the startup must then exceed that valuation in the Seed Round. If a founder is not sure about the value, they may want to consult with experts before choosing a number to share with investors.

Not Striking a Balance Between Flexibility and Assertiveness

Startups must be aggressive in going after funding, but they must also be flexible in setting investor terms. If they are too aggressive, they will push investors away. If they are too passive, the startup may end up with unfavorable terms. Startups must find the right balance between being assertive and being flexible. An attorney may be able to assist with finding this balance.

Focusing Only On the Valuation Cap

Valuation caps are an essential part of raising startup funding, but there are other aspects that founders must also pay attention to. Startups should also focus on dilution, governance rights, and liquidation preferences, as these are also crucial parts of investing.

Failing to Understand the Investor’s Perspective

Investors expect a return on their investment and understand that they are taking a risk by investing. However, their perspective is generally much more nuanced than that. Investors will have varying expectations on exit strategies, holding periods, and details regarding the return on their investment. Investors also have different priorities and motivations driving them to make the investments they choose to make. A startup’s failure to understand these perspectives could lead to conflict and misunderstandings moving forward.

Failing to Register the Securities

A.R.S. §44-1841 requires the registration of securities before they can be offered for sale, with some exemptions. Startups may not know whether their investment offering is a security and can unintentionally violate this statute. This is a class four felony, and violators can also face a cease and desist order, penalties, restitution, or civil action from the Arizona Corporation Commission.

Arizona broadly defines securities and states that if someone wants to use someone else’s money to finance a business venture, they are probably offering a security. However, startups can consult with an attorney to learn more about whether they are offering a security and the steps they must take to register it before attempting to sell the security.

How a Business Attorney May Be Able to Assist You

Startup financing can be quite complex and confusing, particularly for those founders who have never started a business in the past. A business attorney may be able to provide advice and insights into registering securities, negotiating favorable terms, and finding investors. An attorney may also be able to assist in determining an appropriate valuation cap that convinces potential investors to invest while not diluting the founder’s ownership in their own company. If you would like more details on finding startup financing, Harrison Law, PLLC may be able to assist you. Call (480) 320-2310 for a consultation about all your Arizona startup questions.

© 2025 Matthew W. Harrison and Harrison Law, PLLC All Rights Reserved

This website and article have been prepared by Harrison Law, PLLC for informational purposes only and does not, and is not intended to, constitute legal or financial advice. The information is not provided in the course of an attorney-client relationship and is not intended to substitute for legal advice from an attorney licensed in your jurisdiction.