In the context of convertible notes (a form of short-term debt that converts into equity), the terms "cap" and "uncapped" refer to whether a limit exists on the valuation at which the note will convert into equity shares.
A cap sets a maximum company valuation at which the note will convert. This means that if a company's valuation at the next financing round exceeds the cap, the note will convert as if the valuation were at the cap, effectively giving the note holder more equity for their investment. For example, if an investor provides a convertible note with a cap set at a €10 million valuation, and the company's next funding round values the company at €15 million, the note converts as though the valuation was €10 million, meaning the investor receives more shares.
Conversely, an uncapped note doesn't have a maximum valuation limit set for conversion. This means the note will convert into equity at the valuation of the next financing round, regardless of how high it may be. In this case, the note holder takes on more risk as they could end up with less equity if the company's valuation significantly increases at the next round.
The cap in a convertible note benefits investors by providing them with downside protection and potentially a greater ownership stake in the company if the valuation rises significantly. On the other hand, an uncapped note can be more beneficial to the company, as it could lead to less dilution of existing shareholders' equity in the event of a high valuation in the subsequent round.
