Fundraising

Fully diluted ownership

Investors and employees think in percentages, and the percentage that matters is ownership of the fully diluted company: every share outstanding plus every share that could become outstanding under existing commitments. That includes granted options, shares reserved in the option pool and, depending on who is counting, the shares SAFEs and convertible notes will turn into.

Take a company that authorizes 10,000,000 shares. Two founders buy 4,000,000 each, and an investor then buys 889,000 shares of common stock.

The remaining 1,111,000 authorized shares are unissued and belong to nobody. Now suppose the board adopts a stock plan with a 1,000,000-share pool. The fully diluted total becomes 9,889,000, and each founder's fully diluted stake falls to about 40 percent, although no shares changed hands.

So when you offer someone equity, state it in shares and give them the fully diluted total, so they can work out their own percentage. And when you read a term sheet, check what its definition of fully diluted includes, because that definition can move a great deal of money.

Convertible notes

A convertible note is a loan that turns into stock instead of being repaid. The investor lends money, the loan accrues interest, and when the company raises a priced round the principal and interest convert into shares of that round, usually at a better price than the new investors pay. The terms that matter are the valuation cap, the highest valuation at which the note converts; the discount off the round price, commonly 15 to 25 percent; the interest rate; and the maturity date, when the loan falls due if no round has happened. Maturities are usually extended in practice, but a matured note is still debt, and it can give a noteholder leverage at a bad moment. Notes are less common at seed than they used to be, because SAFEs do the same job without interest or a maturity date.

SAFEs

A SAFE, or simple agreement for future equity, was introduced by Y Combinator in 2013 and is now the most common way to raise a first round. The investor pays now, and the company promises shares in its next priced round. A SAFE is not debt: it has no interest or maturity date, and the company never repays it unless the company is sold or dissolved first.

Most SAFEs today are the post-money SAFE Y Combinator published in 2018. Its valuation cap is measured after all the SAFE money is counted, which makes each investor's ownership easy to work out: the investment divided by the cap. An investor who puts $500,000 into a SAFE with a $10,000,000 post-money cap will own 5 percent of the company as it stood just before the priced round, and is then diluted by the round along with everyone else.

SAFEs come in a few variants. One with a cap converts at the cap price or the round price, whichever is lower. A discount-only SAFE converts at a percentage of the round price, often 80 percent, with no cap; it is less common because it gives the investor no protection if the valuation soars. One with both a cap and a discount gives the investor whichever produces more shares. And a most favored nation SAFE has neither, but lets the holder adopt better terms the company later gives other SAFE investors before the priced round; it is often used for very early checks from friends and angels.

If the company is acquired before a SAFE converts, the holder receives the greater of their money back, the cash-out amount, or what they would have received had the SAFE converted to common stock at the cap price. If the company dissolves, SAFE holders are repaid before common stockholders, to the extent anything is left.

Many investors ask for a pro rata right, the right to buy enough of the next round to keep their percentage. On the standard post-money SAFE it is granted in a separate side letter, so it is an explicit decision for each investor.

SAFEs are easy to sign, which makes it easy to sign too many. Every post-money SAFE dilutes the founders, and several at different caps add up quickly. Before you sign each new one, model the cap table with every outstanding SAFE converted, so you know what the founders will own after the priced round.

Preferred stock

In a priced round, investors buy newly created preferred stock at a negotiated price per share, set from a negotiated pre-money valuation. The first one is usually called the Seed or the Series A. Its terms are agreed in a term sheet and then documented in a stock purchase agreement, an amended and restated charter and several investor agreements, and most U.S. venture rounds use documents based on the National Venture Capital Association's model forms. The arithmetic is simple. The price per share is the pre-money valuation divided by the fully diluted shares before the round, investors receive their investment divided by that price, and the post-money valuation is the pre-money valuation plus the new money.

Preferred stock carries rights common stock does not. The most important is the liquidation preference: when the company is sold or wound up, preferred holders are paid before common holders. The market standard is a 1x non-participating preference, under which each preferred holder receives the greater of its original investment or what it would get by converting to common. Participating preferred, which takes its money back and then shares in the rest, is rarer and costs founders more. Preferred converts into common at the holder's choice, and automatically in an IPO or when a set majority of preferred holders agrees.

Anti-dilution protection adjusts the conversion price of earlier preferred if the company later sells shares at a lower price, so those holders receive more common shares on conversion. The standard formula, broad-based weighted average, is moderate; a full ratchet, which resets the price entirely, is rare and harsh. Protective provisions list actions the company cannot take without approval from a set majority of the preferred, such as selling the company, creating senior stock, changing the preferred's rights, paying dividends or enlarging the board. They give investors a veto over fundamental changes even while they own a minority.

Investors usually also negotiate board seats, so that a Series A board might be two founders and one investor, or two of each with an independent director. Larger investors get regular financial statements and the right to take part in future rounds. And the investor agreements usually include a drag-along, which requires stockholders to support a sale that the board and a majority of investors approve, a right for the company and investors to buy founder shares before they are sold to outsiders, and a right for investors to sell alongside founders who sell.

One more term deserves attention. Investors often require the company to enlarge its option pool as part of the round, counted in the pre-money valuation. Because the new pool sits in the pre-money, its dilution falls on the existing holders rather than on the new investors, so the pool size is a real economic term, not housekeeping.

Who can invest

SAFEs, notes and stock are all securities, and selling them requires either registration with the SEC or an exemption. Startups rely on exemptions, whose rules limit who can invest and how you can find them.

Most startup rounds rely on Rule 506(b) of Regulation D. It allows unlimited money from accredited investors and up to 35 others who are financially sophisticated, as long as the company does not advertise the offering publicly. Selling to non-accredited investors under 506(b) triggers disclosure requirements close to those of a public offering, so most startups sell only to accredited investors. An individual is generally accredited with income over $200,000 (or $300,000 jointly with a spouse or partner) in each of the last two years and the expectation of the same this year, net worth over $1,000,000 not counting their home, or certain securities licenses. Rule 506(c) does allow public advertising of a round, but then every investor must be accredited and the company must take reasonable steps to verify it, usually by reviewing financial documents or getting a letter from a professional.

After the first sale in a Regulation D offering, the company must file a Form D with the SEC within 15 days, and many states require a notice filing and fee when their residents invest. These are short forms that are easy to forget.

A few things cause most of the trouble: paying someone who is not a registered broker-dealer a commission for bringing in investors, which can give those investors the right to undo their investment; talking publicly about an open round while relying on Rule 506(b); and taking money from friends and family who are not accredited without understanding what that requires.