Foundational Equity

1. Unequal Split Among Founders: It highlights that most cofounder teams split equity unequally, especially in teams with three or more founders. For instance, among two-founder teams, the median equity split is typically around 55% to 45%.
2. Vesting Schedules for Founders: It emphasizes the importance of vesting schedules for founders, recommending a typical period of at least 4 years. Vesting schedules prevent founders from leaving early with a sizeable equity stake and are usually provided in the form of Restricted Stock Awards (RSAs).
3. Sources of Dilution: Founders, early employees, advisors, and fundraising activities contribute to dilution, impacting the ownership held by initial stakeholders.
4. Vesting Schemes: Different stakeholders (founders, employees, advisors) have different vesting terms. For example, advisors usually have vesting periods of 2 years with a short cliff, while employee equity typically vests over 4 years with a one-year cliff.

Equity Grant Structure

1. Foundational Team (Employees 1-3):
   • Roles: Critical functions such as CTO, COO, or heads of core departments.
   • Equity Range: 1% to 3% per person.
   • Vesting Schedule: 4 years with a 1-year cliff.
   • Considerations: Offer higher equity to candidates with significant industry experience or network value.
2. Core Team (Employees 4-6):
   • Roles: Key contributors with specialized skills important to early operations (e.g., Senior Developer, Head of Marketing).
   • Equity Range: 0.5% to 1% per person.
   • Vesting Schedule: 4 years with a 1-year cliff.
   • Considerations: Adjust equity upward if their role requires unique expertise or if the candidate's skills are high in demand.
3. Essential Support Team (Employees 7-10):
   • Roles: Essential but more specialized or tactical roles (e.g., Product Manager, UI/UX Designer).
   • Equity Range: 0.1% to 0.5% per person.
   • Vesting Schedule: 4 years with a 1-year cliff.
   • Considerations: Offer flexibility in initial compensation versus equity to match individuals' risk appetite and cash needs.

Carta State of Pre-Seed Q3 2024

Based on the current trends in pre-seed funding from your document, here are some practical insights and strategies for equity and fundraising for a startup at this stage:

1. Leverage SAFEs and Convertible Notes Carefully: It appears that SAFEs with a discount rate and no valuation cap have become more prevalent in 2024. This suggests a shift in investor preferences towards instruments that provide more upside potential without limiting future valuation through a cap. Consider offering terms that align with these trends if your fundraising circumstances allow.
2. Focus on Smaller Check Sizes for Pre-Seed Rounds: Most of the pre-seed activities are increasingly represented by smaller deals, with checks under $250K making up a larger share of the activity (42%). If your funding need aligns with this, it might be prudent to target a larger number of smaller investors rather than a few with larger checks.
3. Industry Specific Strategies: If you're in a high-valuation cap industry such as hardware or finance, consider leveraging these benchmarks to argue for a higher valuation cap if using SAFEs. Tailor your pitch to emphasize the growth potential and industry-specific advantages.
4. Prepare for Post-Money Valuations on Convertible Notes: The document mentions that post-money conversions on convertible notes are no longer rare. Understanding this trend can help you better negotiate terms that protect your equity dilution by anticipating how future valuation can affect your stake.
5. Develop a Diverse Funding Strategy: Adapt your fundraising strategy based on the current trend towards diverse instruments and smaller, more distributed funding rounds. Consider engaging with platforms that specialize in managing such instruments efficiently.

• In 2024, 31% of pre-priced rounds (5408/17483) is over $1M
• 42% of pre-priced deals are under $250K
• Nearly 90% of pre-priced rounds in Q3 were raised on SAFEs (12% Convertible Notes)
• In software, 90% SAFE vs 10% Convertibles notes
• Value Cap
  • 89% of SAFEs had a valuation cap; 46% had a discount rate
  • $1M - $2.4M rounds - value cap: [$10, $14, $20M] [25, 50, 75 percentile]
  • $2.5 - $4.9M rounds - value cap: [$15, $20, $30M] [25, 50, 75 percentile]
• Dilution benchmark
  • for $1M-$2.4M: [13.5%, 17.9%, 28.6%] [25-50-75 percentile]
  • for $2.5M-$4.9M: [19.2%, 25.6%, 32%] [25-50-75 percentile]
• Most checks are > $250K (58% for $500-999K; 78% for $1-2.4M; 90% for $2.5-4.9M)
• Raise $3mil at an average $250K per SAFE = 12 SAFEs to fill out the round

SAFE vs Convertible Notes

Both instruments are popular because they allow startups to postpone the challenge of setting a valuation, provide flexibility to both investors and startups, and facilitate quicker deal closure compared to traditional equity investments. They're particularly common in early-stage funding because they simplify complexities associated with investment negotiations.

SAFE

Simple Agreements for Future Equity

• Definition: SAFEs provide a way for startups to raise funds without immediately determining a valuation. They are agreements that convert into equity in the future, typically at the next funding round.
• Mechanism: Investors provide capital now and receive the right to convert that investment into shares at a future date, usually at a discounted price compared to the market rate at the next financing event.
• Key Features:
  • No interest rate or maturity date, unlike convertible notes.
  • Often include a valuation cap, which limits the price at which the investment can convert into equity.
  • May also have a discount rate offering investors a price reduction relative to the round's valuation.

Convertible Notes

• Definition: Convertible notes are a form of debt that converts into equity at a later stage, typically during a subsequent funding round, upon achieving certain conditions.
• Mechanism: Structurally closer to a loan with an interest rate and maturity date, convertible notes accrue interest, but convert into equity once the trigger event (like a new investment round) happens.
• Key Features:
  • Initially considered a debt, thus having a specified interest rate and repayment terms.
  • Can have both a valuation cap and a discount rate, similar to SAFEs.
  • They include a maturity date, after which they are due unless converted into equity.

Priced Equity

A priced equity investment refers to a financing arrangement where the valuation of a startup is explicitly determined and agreed upon during the funding round. This type of investment involves the sale of company shares to investors, with the terms reflecting the company's assessed valuation. Here are the key elements:

1. Determined Valuation: Unlike SAFE or convertible notes, a priced equity round requires the company and its investors to explicitly agree on the company's valuation at the time of investment. This valuation directly impacts the price per share that investors pay.
2. Issuance of Shares: In a priced equity round, investors receive a set number of shares based on the amount they invest and the agreed-upon valuation. Their ownership percentage in the company is clearly defined at the outset.
3. Common Types:
   • Seed Funding Rounds: Early-stage companies might engage in priced equity rounds when they want to establish a clear valuation and are prepared for the associated diligence.
   • Series A and Beyond: As companies grow and require larger sums of capital, priced equity rounds become more common to give both the company and investors a clear understanding of company ownership and valuation.
4. Implications:
   • Investors are taking on more risk by tying their investment directly to the company's current valuation, which implies a more thorough due diligence process.
   • Priced rounds tend to provide immediate clarity on ownership and can set a precedent for future investments.

Using priced equity investments often indicates a level of maturity and stability in the business and can signal to the market and other investors a credible valuation benchmark. If your company is considering a priced equity round, it would be beneficial to ensure your business metrics support the valuation you're aiming for, to attract investors and negotiate effectively.

Dilution Benchmark

A dilution benchmark refers to a standard or guideline used to measure the acceptable or typical level of dilution that a company's founders and existing shareholders might expect when raising a new round of investment. Dilution occurs when new shares are issued, reducing the ownership percentage of existing shareholders. Here’s how dilution benchmarks work:

1. Typical Levels by Stage:
   • Seed Stage: Founders often see dilution of about 10-20% in this early stage as investors take on higher risks.
   • Series A and Beyond: Dilution can range from 15-25% per funding round, depending on the amount raised and the specific valuation terms.
2. Guidance for Founders:
   • Strategic Planning: Dilution benchmarks help founders plan and negotiate funding rounds to maintain a significant enough ownership percentage to retain control and motivation.
   • Pacing Growth: Setting benchmarks aids in pacing growth and fundraising to avoid excessive dilution too quickly, which can destabilize ownership and control.
3. Negotiation Tool: Understanding industry-specific dilution benchmarks allows startups to negotiate better terms with investors by setting expectations that align with market norms.
4. Variability Factors: Benchmarks can fluctuate based on factors like market conditions, industry type, company's stage of development, and investor appetite. High-growth potential sectors might command more favorable terms, thus experiencing different dilution rates.

Using dilution benchmarks effectively involves balancing the need for capital with the desire to preserve control and maximize long-term company value. They give founders a reference point to evaluate whether the dilution from a proposed investment aligns with their strategic goals for company growth and personal ownership stakes.

Limited Partners

Limited Partners are investors in venture capital and private equity funds. They typically contribute capital to the fund, which is managed by General Partners (GPs) who make investment decisions on their behalf. In the context of convertible notes, when it refers to LP check sizes, it indicates the investment amounts that individual limited partners commit to these convertible note funding rounds. Their involvement in such investments is usually through a venture fund or a similar investment vehicle, and a check size of $300K or more indicates a relatively substantial investment from each LP.

RSA vs RSO

RSAs (Restricted Stock Awards) and RSOs (Restricted Stock Options) are both forms of equity compensation used by startups and companies to incentivize employees, but they have distinct characteristics and implications. Here’s a breakdown of each:

Restricted Stock Awards (RSAs)

1. Nature of Grant: Employees receive actual shares at the outset. These shares are subject to vesting conditions, meaning they aren't fully owned by the employee until they vest according to the schedule.
2. Ownership: Since RSAs are shares, recipients have shareholder rights from the start, including voting rights and the potential to receive dividends.
3. Taxation: Upon receiving RSAs, employees might face taxable events, but they can make an 83(b) election to pay taxes on the grant date value instead of the vesting date value. This can be advantageous if the stock’s value appreciates.
4. Common Usage: Often used for early-stage startups when the company’s valuation is low, minimizing upfront tax impact for employees.

Restricted Stock Options (RSOs)

1. Nature of Grant: RSOs provide the right to purchase shares at a specific price (exercise price) in the future. They do not entail ownership until exercised.
2. Ownership: Unlike RSAs, employees don’t have shareholder rights with options. They only gain such rights upon exercising the options and acquiring the shares.
3. Taxation: No taxable event occurs until the options are exercised. When employees exercise options, they pay taxes on the bargain element (difference between market value and exercise price).
4. Common Usage: Frequently used in later-stage companies or when stock value is higher, aligning taxation with the economic benefit received.

Key Differences:

• Ownership Timing: RSAs confer immediate ownership (subject to vesting), while with RSOs, ownership only occurs upon exercising.
• Tax Implications: RSAs can lead to early tax events but allow for potential tax advantage through 83(b) election, whereas RSOs delay taxation until exercise but can lead to higher taxable income if the stock value increases substantially.
• Company Stage Consideration: RSAs are favorable in early-stage scenarios where stock value is minimal, while RSOs are often used as companies grow and valuations increase.