In early 2022, more than 70% of founders said they care about their own personal equity, but over half of those founders also said they didn’t know how to maintain their founder equity and incorporate it into the startup’s greater equity strategy.
In our experience, founders are often surprised how various different securities combine and play off each other to create higher dilution for their founder equity than they originally expected. So what are the questions you need to ask yourself as a startup founder? How do you incorporate your founder equity into your startup’s equity strategy?
TL;DR answer: you need to model it out.
As the founder, you’ll need to model out multiple rounds of funding. For those founders who are using convertible instruments like SAFEs, there are a few extra things to consider like where you set your valuation cap, your expected growth, and how many SAFEs you're planning to raise at once.
Modeling expected valuation
Convertible instruments allow startups to raise money more quickly because valuation does not need to be established (that is, the instrument converts in future once a valuation is established in a qualified financing event). It’s less negotiation and lower legal fees. Therefore, stock is not issued with these financing instruments until they convert. The catch is that sometimes it’s hard for founders to understand personal dilution without fully modeling all convertible instruments plus the subsequent round of funding that triggers the conversion.
Now in order to fully understand how that affects your founder equity, there are two key terms to note: the discount and valuation cap. A discount is simply a percentage discount on the per share price of stock sold in a financing. A "valuation cap" entitles note holders to convert the outstanding balance on the note into shares of stock at the lower of (a) the valuation cap or (b) the price per share in a qualified financing (or, if there is a discount in the note, then the discounted price per share). It is intended to ensure that an investor does not miss out on significant appreciation of a company between the time of the sale of convertible instruments and the qualified financing.
Notes convert (with a discount) into stock at the next qualified financing event (QFE). Let’s use the example of raising $250K on a 4M valuation cap to see how this works in practice.
Note in this example, the founder plans to raise $1M in additional funding at their next round. By raising their next round at a $4M pre-money valuation, the new investment will translate into 20% of the total equity of the company.
The convertible instrument converts from the common stock of the pre-money valuation. Because the valuation cap matches the valuation, the convertible instrument will translate into 5% of the post-money valuation. The share price for the convertible instrument was established during the original deal. The equation is as follows:
Share price = Pre-money valuation/pre money total shares = 4/6 = $0.67
And because the valuation cap is the same as the pre-money valuation of this qualifying financing event and there is not a specific discount written in the agreement, the discount is calculated as follows:
Effective discount = 1 - cap/pre-money valuation = 0
With a discount of 0, the convertible instrument translates directly into $250K of the pre-money valuation, diluted from the common stock owned (in this case) by the founder.
*Note if a discount is classified in the original convertible instrument deal, either the classified discount or effective discount from the equation above (whichever is larger) would be used.
Now what happens if the valuation cap doesn’t equal the pre-money valuation?
Now for this example, let’s take the same $250K note but raise it on a $2M cap (and with all other factors the same).
Share price = Pre-money valuation/pre money total shares = 2/6 = $0.33
Now considering this is half of the share price of our previous scenario, the convertible instrument will be expected to provide double the amount of equity for the investor at the pre-money valuation of $4M. This would result in 10% of the equity going to the convertible instrument, of which is diluted from the founders once again.
So what are the most common mistakes founders make?
- Valuation cap is much lower than QFE
A valuation cap that is much lower than the pre-money valuation of the next qualified financing event, will lead to high dilution of the initial common stock. Additionally, incoming investors might perceive their investment terms as unfair given the original investors who used a convertible instrument will be receiving far more equity per dollar of investment.
- Valuation cap is deemed too high
When the original valuation cap is much higher than the pre-money valuation of your next financing event, it could be a bad signal to subsequent investors that you are not growing at the rates you were initially expecting. This may lead to increased wariness on behalf of the investors around your future growth or growth trajectory. And the existing investors who deployed capital via convertible instruments may feel like they didn’t get a fair deal.
- Stacked convertible notes at different terms
Calculating the implications of multiple convertible notes at different terms can get complex quickly. For your particular stage (particularly in the earliest of stages), you’ll want to try to use the same terms across multiple notes. A Most Favored Nation (MFN) clause will further complicate this because those with this protection will benefit from negotiations others make. Pro rata side letters may further complicate the picture and result in further founder dilution.
- Negotiate any valuation caps wisely.
What’s immediately apparent in the modeling is that valuation caps can have a huge effect on how a convertible instrument translates into equity and ultimately how much of your founder equity will be diluted after a particular financing event. Because of this, you’ll want to make sure you negotiate a valuation cap that best fits what you believe your pre-money valuation will be in your next financing round. Benchmarking against industry standard
- Use standardized templates (SAFE, KISS, Techstars note) and standardize terms across different notes
One easy way to decrease complexity and utilize some protections that have been developed over time is to use standardized templates from the likes of Techstars or 500 Global (formerly 500 Startups) or Y Combinator who pioneered SAFEs as a way to get money to early-stage companies quickly.
- Consider non-debt instruments (SAFEs) where the maturity date is defined by the QFE
In our simplified examples today, the maturity date was defined by the next qualified financing event. There are some notes that are defined by a time-bound maturity date (for example, 12 months after issuance). These can often force founders into additional financing or skewed valuations that may not be at their benefit as a company.
If you’re looking to model out multiple scenarios of fundraising or take a look at how your SAFEs may convert, LTSE Equity has one of the most tried and true scenario modelers across equity management platforms. You can learn more here and test out our scenario modeler in our demo.