This piece draws from a conversation with Henry Ward, who is the Founder and CEO of Carta, which builds infrastructure to help manage equity and compensation for startups, and manage private capital funds. As a founder and CEO of a high-growth startup himself, Henry shared his insights on the biggest things that founders need to know about early-stage financing.
When asked how founders should think about dilution, Henry suggested, “For startups, there are really two outcomes that really matter — death, or success. There’s not much in the middle, so it’s your job to try not to die.”
This binary startup outcome means success is surviving long enough to hit it big. If you do hit it big, you’ll never remember a point here and there of dilution or what your valuation was at what round. These are what tend to get all the attention at the early stage of a company.
As a follow-up, Henry suggested that what founders should really just focus on instead are questions like “how do I get capital” and “how do I accelerate the business”. Worrying about percentage points of dilution usually ends up being a waste of time.
So, as Paul Graham wrote in his essay How Not To Die, “Don't give up.”
That said, there are some key things I learned in our discussion with Henry during his journey as founder and CEO of Carta about valuation, dilution, cap tables, and explaining equity to employees that founders most need to know.
Key lessons around equity and early-stage financing
Startup founders should understand these key topics yet many don’t:
- Valuations, How 409As work, and finding a market-clearing price
- Dilution and Types of financing and Impact Convertible notes vs. equity funding
- Employee compensation and explaining the value of your equity
Valuations and How 409As work
Value is how much an asset is worth; price is what someone is willing to pay for an asset.
How 409A valuations work
Carta describes a 409A like this:
“A 409A valuation is an independent appraisal of the fair market value (FMV) of a private company’s common stock (the stock reserved mainly for founders and employees). This valuation from section 409A of the IRS’s internal revenue code (IRC) determines the cost to purchase a share.”
The IRS rule is that you have to update that strike price either once a year or any time there’s a “material event”. What that means is subject to interpretation, but the most common “material event” that startups will have is raising a new round of financing. That’s why the IRS implemented a rule that a third-party like Carta, which does 409As for a lot of startups (over 1000/month these days), to set the valuation and a per share strike price. Before 409As existed, companies set whatever strike prices they wanted.
Generally, this means the strike price of the 409A goes up over time because the company’s value has gone up. Any new stock options issued after that point will be at the new (increased) 409A price. The strike price, also known as an exercise price, is the price to exercise a stock option. If a company issues an option at a strike price of $1, it means that if you hold the option you can buy the stock for $1 regardless of subsequent changes in valuation or any market value.
What this means is that startup employees generally want the lowest possible strike price when options are issued, to be able to capture more upside as the company grows in value over time. Founders need to be aware of it and its implication for the process of issuing stock options, especially since it’s such a critical hiring tool for startups.
Cap tables and software
In order to track your valuation and ownership levels, founders need a Capitalization Table to keep track of who owns how much and what type of ownership stock — whether preferred, common, or non-standard preferences.
Historically, this used to be done manually via spreadsheets, which was a big pain to manage and error prone. Carta launched as eShares in 2012 to issue and track securities in addition to conducting 409A valuations making it easier to automatically keep track of big venture investors, small checks, SPVs, group investors, etc.
Now, every time you raise a new round you can use software to model the new round, the shareholders and who owns them, the waterfall model, etc. Stock certificates are then issued to new employees, and option grants can be issued to employees as well.
Finding a market-clearing price
Henry suggests, “[a]s a founder, you should always seek to find the market-clearing price when you’re raising a round.” The market-clearing price is the highest bid you get in a term sheet, under the same set of terms about how much equity you’re giving up and in what manner you’re giving it up. He recommends trying to get more than one term sheet, compare each and find the market-clearing price holding all terms equal.
Before I explain further, a couple of key terms:
- Pre-money valuation is the valuation of a company at the time of funding, minus the value of the capital amount raised.
- Post-money valuation is the valuation of a company at the time of funding, including the value of the capital amount raised.
Terms can include the offer valuation which can be offered at pre-money or post-money, amount raised, voting rights, protective provisions, participation, ratchet amount, liquidation preferences, shareholder protections, etc. Typically you want to aim for standard terms: 1x preferred stock, no dividend, and no sophisticated waterfall.
Importantly, Henry suggested that your job as a founder “is to find that market-clearing price and then pick the investor at that price you want to work with.”
For example, if a founder received three term sheets for a Series A. The first values your company at $100M, the second at $90M, and the third at $80M, but you want to work with the investor valuing you at $90M rather than the $100M investor. He suggested that “you can always go to the $90M investor and say “hey, I have a term sheet at $100M — I’d rather work with you if you could match the terms.’"
Dilution: what founders need to know
Another major area to understand when fundraising is dilution. Dilution is when you give up ownership to an outsider in exchange for capital or resources. In our interview, we discussed the following example.
How dilution works is as follows: let’s say you raise $2M at a $20M post-money valuation for your seed round. Your seed investors then own 10% of the company (2M out of a total 20M).
But then you raise a $10M Series A at a $100M post-money valuation where you give up 10% of the company to the Series A investors. This dilutes the whole cap table by 10%, meaning the seed investors now own 9% of the company at the Series A vs. the 10% ownership they had at seed. In total, in this scenario, the seed and Series A investors collectively own 19% of the company.
Henry noted, “Ultimately, there’s a diminishing capacity for dilution as the valuation of the company goes up. It’s one of those things that can sound worse than it really is. I’ve observed that founders tend to be oversensitive to dilution, especially in a market when capital has been very available. As mentioned earlier, worrying about percentage points of dilution tends to be a waste of time.“
Tradeoffs between convertible notes & equity
On financing instruments, Henry shared that one of the big misunderstandings around early-stage financing is the difference between convertible notes and priced equity rounds.
Specifically, he noted convertible notes are perceived as cheaper than priced equity. “[Founders] think it’s cheaper than doing an equity round — which it may be, on the margin. But these days, doing seed equity financing is comparatively inexpensive, and the only thing you might be giving up with equity financing is some governance. On the other hand, the cost that most people don’t realize with convertible debt is that it’s a full ratchet, as opposed to a seed round via equity, where there may not be any anti-dilution.”
For context, a full ratchet means there’s no downside on the debt for the investor. If you raise below your cap the debt investors will participate full price. With equity rounds, in the event of a downside valuation event, your investors participate in the downside risk alongside you.
For example, if you raise a seed round of $2 million in convertible debt on a valuation of $20 million, but then raise your next equity round at a valuation of $10 million, the $2 million from the initial seed round will convert to 20% of the company that you’ve now given up, when initially you might have been thinking you were only giving up 10%. This is because the $2M you raised was only 10% of your seed valuation, but 20% of your $10M down round.
On the flip side, if your seed round had instead been an equity investment of $2M on a $20M valuation followed by a down round at $10M, the equity investors’ stake would now only be worth $1M (not a full ratchet) — since the equity investment scales down with the valuation of the company. and retains the same percentage ownership. Henry shared that while uncommon, anti-dilution provisions can happen in Series A and B rounds noting that a “half ratchet” is volume-weighted amount. Henry’s contrarian view is that the early stage may be better off doing priced equity seed round rather than a convertible due to the downside protection.
The tradition of doing convertible notes became a thing when people were raising $800k-$1M seeds, and it cost $25k to close a seed round if you used traditional equity. Convertible debt was not as potentially punitive to the cap table when you’re raising at a pre-money valuation of $10-$15M because the odds were low that you were going to have a down round. However, with high early-stage valuations it’s very possible to see convertible notes at a much higher cap and risk of down-rounds. Henry noted at Carta, they’ve seen startups take convertible notes with pre-money valuations of up to $100M which is a high risk situation for downround.
Preferred stock and non-standard preferences
Almost all venture deals are done on a preferred stock basis. What is a preferred stock? Preferred stock means that investors get a minimum of 1x their investment back, and they also participate in any upside.
Let’s say, for example, you raised a $10M Series A at a $100M post-money valuation. Since the investors put in $10M, they own 10% of the company. Suppose that you then sell the company for $50M — how much would the investors get?
If they were common stockholders, they would get $5M (10% of the $50M sale). But since investors own preferred stock with downside protections such as liquidation preferences. This means they get the greater of either 1x their investment or 10% of the proceeds of a sale. So in this scenario, they would get their full $10M back even though they technically own 10% of the company.
Henry noted that, “[s]ometimes, investors can put in punitive terms when they offer a term sheet, which might have a provision that gives them something like whichever is the greater between 1.5X (as opposed to 1X) their capital investment or the proceeds from selling their percentage ownership.”
To see why terms like this are punitive, consider the scenario of raising $10M at a $100M post, but now with terms that guarantee 1.5X of the invested capital back to the investor. If you sold your company the next day for $100M (i.e. the post-money valuation), the investors would get $15M back on their $10M investment from the day before, even though the valuation of the company was identical to its price at sale. This penalizes all the other shareholders because they receive $85M instead of $90M. Founders can use Carta to evaluate scenarios and model out fundraising strategies and how each scenario impacts outcomes.
Henry’s advice is that founders “stick to standard terms in their term sheets”. That while sometimes in a tough market the only way you can get capital is by accepting more onerous terms required by investors. “Oce you give up a non-standard preference like a 1.5X preference, you’ll have set a precedent for the next round of investors who will want the same terms.” For example, if your Series B investors see the Series A investors' terms, they will want it. Same for Series C, and so on. Given this, it will be hard for you to say no to giving them all preferential structure since it has been done before. This can end up mattering much more than dilution.
Ultimately, understanding ratchets is more important, and so is creating a competitive bidding process and getting the top bid you can at standard terms. You want to find as many bids as you can get, zero in on the best bid, and then decide how you want to structure the transaction.
Employee compensation and explaining the value of your equity
The final thing we discussed was employee compensation and dilution for organizing their employee option pools. Carta’s data shows that usually the size of employee option pools range from 10-12% and can help you decide the size of your employee option pool . The employee option pool is paid for by the existing shareholders and investors, so the option pool is usually set up in the pre-money cap table.
Startup equity is one of the most powerful tools that startups have to attract talent, because bigger companies can usually offer more cash compensation, stability, and lifestyle balance.
To counteract this, startups issue equity to employees so that they have the chance of sharing in the potentially high upside of owning a venture-backed, high-growth business.
Carta also makes issuing and managing the equity to employees and stakeholders easier with Carta Total Compensation, and even provides compensation tools for companies and tax advisory solutions for employees.
Explaining the value of your equity
The number one thing founders can do to improve the equity experience for employees at early-stage startups, and therefore to help attract and align the best talent, is educating everyone about how equity works.
Tools like Carta are useful for helping employees understand their compensation. It’s also good to help employees understand how taxes and strike prices work and what exercising an option means so that they can really understand the potential value of their equity.
Carta has a free online course that founders can use as a resource to send to their employees on Equity 101, with people like Serena Williams and Steve Nash. I think all founders should try to educate their employees of the value of their equity as a way of incentivizing the right hires and keeping them motivated when they join.
Henry’s advice was “once you convince somebody of the upside of joining an early-stage startup and owning equity in general, it’s also important for founders to answer the question “why is this startup’s equity the equity I should own versus another company” for prospective hires. This is where you paint the picture of why your equity is going to have a higher chance of being worth more than other companies; it’s telling the story and communicating the vision of your company.”
Early-stage financing does a good job of aligning the founders and investors. It can also do a great job of aligning employees, provided they are given an understanding of the company, of how equity works, and of the vision. When the founder has done a good job of explaining that, it’s super powerful.