A valuation cap is the maximum company valuation at which a SAFE or convertible note converts into equity at a future priced round. The cap holds regardless of how high the actual round valuation turns out to be. It is the price ceiling that rewards an early investor for taking risk before the company had a priced valuation.
The mechanic is straightforward. An investor puts in $100,000 on a SAFE with a $5 million valuation cap. The company later raises a priced Series A at a $25 million pre-money. Without the cap, the investor would convert at the Series A price and own a small slice. With the cap, the SAFE converts as if the company were valued at $5 million, so the investor effectively gets shares at one-fifth the priced-rou...