For early stage companies and seed capital investors, it is a mechanism that sets the maximum valuation level (cap or upper threshold) at which a convertible security (or other forms of securities, e.g., SAFEs) attains its conversion price. Both convertible notes and SAFEs are used to convert equity upon occurrence of specific trigger events, typically at the next stage of funding.

These instruments are, in essence, forms of debt that converts to equity when a triggering event takes place. Typically, the trigger event can be defined in a situation where a start-up company completes the next round of financing. Earlier in the structure, a security is issued and sold to investors who practically lend money to a startup. The investors receive interest on the outstanding debt, and upon conversion to equity, the principal and interest are converted from the state of debt into equity.

Convertible instruments typically offer a discount and a conversion cap. The instrument converts into equity at a conversion price equal to the issuing company’s valuation in the next round of financing. A conversion cap results in the conversion of the amount invested into equity at a maximum price (even if the value of the company at the next round of financing exceeds the level of the cap). For example, if the valuation cap was set at $2 million but the company’s valuation at the next financing round was $2.5 million at the time, the amount invested would convert into equity at the $2 million conversion cap.

It is also known as a valuation cap.