We decided for our final project to fund the company we are looking at through a convertible note. The big issue for us was whether to include a valuation cap, and if so, what amount. At first, we thought no cap and just provide a discount. It would be much simpler this way. But after reading some, having no cap seems to be the exception not the rule. The reason for the valuation cap, is to protect the investor just in case the company goes for a huge pre-money valuation later. The valuation cap allows us to ensure that we will at least get a certain portion of the equity for the amount we originally invested in. There’s a great discussion here: https://shockwaveinnovations.com/2013/04/06/justifying-the-cap-amount-in-your-convertible-note/
I agree with the author here in the sense that the valuation cap is not a valuation of the company, but more of a protection mechanism to ensure that we would get a certain amount of equity. But I do think a certain amount of valuation needs to take place and timing of a potential new qualified financing. The way I approached our term sheet was to anticipate when I thought the next round of financing would come, for how much money, and for what % of equity. Then I would figure out what the pre-money and post-money valuation would be, and then back in what I thought the appropriate amount of equity I should have at that point.