Modeling Dilution

How much of your company do you actually own? How much will you own if you are acquired or IPO? Planning your company's equity roadmap is important so you don't give away too much of the company in the early days. Remember once you give away a chunk of your company, you can't get it back.

There are two approaches to model ownership:

  1. Estimate ownership percentages - you probably have this in a google sheet. This is a rough back-of-the-envelope calculation for who owns what.
  2. Calculating the exact number of shares - Legal documents do not list the ownership percentage because ownership changes as you raise more funding and hire more people. Legal documents include the number of shares. This rule applies not just to investors, but also to employees (i.e. offer letters should show the number of options and not the percentage of ownership).

We'll walk through both approaches in this article.

The short-cut: back-of-the-envelope calculations for ownership

Scenario one: Post-money SAFEs

Calculating ownership is easy if you've only raised on post-money SAFEs. Ownership per investor = Investment ($) / Valuation ($)

Ex:

  • Bob Jones invests $1m on a $10m post-money valuation. Bob's ownership is 10% ($1m / $10m).
  • Sandra Owens invests $1m on a $10m post-money valuation. Sandra's investment does not affect Bob's ownership. Both Sandra and Bob own 10% of the company.

The ownership calculations stack if you raise multiple SAFEs on different valuations. If you raise $1m on $10m (10%) and then another $1m on $20m (5%) with post-money SAFEs, you've given away 15% of your company.

Scenario two: Pre-money SAFEs

The estimated dilution from pre-money SAFEs is harder to calculate because it depends on two numbers that you do not know today:

  1. Total amount raised on pre-money SAFEs - Every additional investor dilutes both you and existing pre-money SAFE holders. You and your investor will not know their final ownership until you finish your SAFE fundraising.
  2. Option pool increase at the series A - The size of your option pool is a term you negotiate with your lead investor at the series A. You cannot know this number today because it also depends on how many options are remaining before your series A. The increase in your option pool dilutes both you and your pre-money SAFE investors.

You can do rough ballpark estimates for dilution from pre-money SAFEs as follows: Ownership = Investment / (Valuation + Investment). Note that all of the ownership calculations will be under-estimates because they assume the increase in the option pool is 0.

Ex:

  • Bob Jones invests $1,000,000 at a $10,000,000 valuation with a pre-money SAFE. Bob owns 9.09% of the company ($1m / $11m).
  • Sandra Owen loves the idea, and also invests $1m on a $10m valuation. Sandra's investment changes Bob's ownership. Bob and Sandra now both own 8.33% of the company ($1m / ($10m pre-money + $2m raised total)). Bob's investment also dilutes Sandra.
  • Every new investor dilutes all existing pre-money SAFE holders.

The complexity around the calculations for pre-money SAFEs is why YC strongly recommends using post-money SAFEs. This approach lets you estimate your dilution plus or minus 10% because it ignores the option pool. This estimate is a rough way to know how much of your company to give away, but it should not be the final estimate to rely upon when you close your A.

Scenario three: Pre-money SAFEs and Post-money SAFEs

The ownership calculation for post-money SAFE investors is not affected by pre-money SAFEs. However, pre-money SAFEs are affected by post-money SAFE investors.

Ex:

  • Bob Jones invests $1m on a $10m post-money valuation. Bob's ownership is 10% ($1m / $10m).
  • Sandy Simmons invests $1m on a $10m pre-money valuation. Sandy's ownership is 9.09% ($1m / $11m). Bob's ownership is not affected by Sandy. This is the benefit of the post-money SAFE. It will always result in predictable ownerships regardless of other investors.

You've given away 19.09% of the company. The final dilution will be higher because it's not factoring in the increase from the option pool increase.

The real math: calculating the number of shares

How do SAFEs convert in an equity round?

Remember that SAFEs are not equity. They are a promise for future equity.  SAFEs convert into shares at your first equity round (i.e the series A). The number of shares issued to SAFE holders is determined by the share price. The share price is calculated by dividing the valuation cap by the company capitalization.

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Company Capitalization is a fancy way of saying the number of shares in the company. This may seem straightforward, but it's not. What's included in the company capitalization is the heart of the calculation, and the definition of this term is the difference between the pre and post-money safe.

Below is a screenshot from YC's post-money SAFE. If you use a modified version of the YC docs, the company capitalization could be different than the screenshot below. Reference your documents to determine the company capitalization.

Post-money SAFE conversion

The company capitalization for post-money SAFEs is defined as the following:

Let's break down each part:

  1. Share of capital stock issued and outstanding - this includes all the founder shares and RSAs issued to early employees
  2. Converting securities - this includes the shares that will be given to all other SAFE or convertible noteholders.
  3. Issued and outstanding options, and promised options - this is the size of your equity pool. It includes both equity granted out of the pool and given to early employees, and options available to grant.
  4. Includes the Unissued Option Pool, except that any increase to the Unissued Option Pool in connection with the Equity Financing shall only be included to the extent that the number of Promised Options exceeds the Unissued Option Pool prior to such increase - this means that the company capitalization does NOT include increases to your equity pool that's required as part of your series A. Most series A term sheets require increasing your equity pool so that you have enough equity to hire talent after your next round. This increase in your equity pool is not included in the company capitalization calculation.

You may be wondering about part 2 - converting securities. How do you calculate the company capitalization if it depends on knowing the number of shares SAFE holders will receive when the number of shares a SAFE holder receives depends on the company capitalization?

This sounds recursive. Because it is! Lawyers typically calculate this number with Excel using iterative calculations which are self-referencing.

Pre-money SAFE conversion

The company capitalization for pre-money SAFEs is defined as the following:

  1. All shares of Capital Stock - this includes all the founder shares and RSAs issued to early employees. This is the same as post-money SAFEs
  2. Outstanding vested and unvested options -  this includes options granted out of your equity pool and available options within your pool. This is the same as post-money SAFEs.
  3. Warrants and other convertible securities - warrants are options for investors. You will unlikely have warrants at the seed stage, but if you do, this would be included in the company capitalization.
  4. Excludes (i) this instrument, (ii) all other SAFEs, and (iii) any convertible promissory notes - this means any shares given to other Safe holders are not included in the company capitalization. This is the key difference between pre and post-money SAFEs.
  5. All shares of Common Stock reserved for future equity plan (a common mistake) - this is the number of shares added to your option pool at the series A. The post-money SAFE does not include this term, but the pre-money SAFE does include dilution by the option pool increase. This term is included in YC template for pre-money SAFEs, and is the most common term we've seen missing at the series A. Be careful if your SAFE agreement includes this term, but it's missing from your pro-forma.

Once you calculate the number of shares included in the company capitalization, calculating the number of shares each investor receives is trivial. The equation is as follows:

  • Share price = Valuation Cap / Company Capitalization
  • Number of shares = Investment / Share price

The heavy lifting of determining how many shares each investor receives is done by your lawyers when they create a pro-forma. We recommend working with a law firm that is familiar with SAFEs and startups because we've seen a lot of pro-formas with incorrect calculations.

How do SAFEs with discounts convert?

SAFEs can have a "discount rate" which gives investors a discount on the Series A share price. You may see both discount and discount rate - they are inverts of each other. The discount rate is 100% minus the discount. For example, if you give your investors a 20% discount, the discount rate is 80% (100% - 20%). This is confusing because colloquially, discount is used more often to describe terms. However, legal documents, like YC's standard discount SAFE agreement, refer to the discount rate.

Discounts can be combined with valuation caps. Here's how dilution works for both:

  1. SAFE note with a discount - the investor will receive the discount of the series A price per share. Ex: If the series A price per share is $1.00 and the discount is 20%, the SAFE will convert at $0.80 per share.
  2. SAFE note with a discount AND valuation cap - the SAFE will convert at the lower price of the two. For example, if a valuation cap resulted in a share price of $1.00 and the discount rate resulted in a share price of $2.00, the SAFEs would convert at the valuation cap price and the discount rate would be irrelevant.

The following is how you calculate SAFEs using a discount:

  1. Calculate the Series A share price - the formula is the following:New Investor share price = (Pre-money valuation) / (Company Capitalization + Number of shares added to the option pool). The company capitalization depends on the type of SAFE you raised on and is described above.
  2. Calculate the share price for the discount - Multiply the discount rate by the series A share price to get this figure.

Ex: If the price paid by your Series A investors is $3.00 per share and the discount was 20%, then the SAFEs would convert at a price equal to ($3.00 x (100-20)%) = $2.40 per share.

How do uncapped SAFEs (i.e. no discount or valuation) convert?

A SAFE without a valuation cap or a discount will always convert at the series A price per share. If a new investor's price per share is $3.00, then the SAFE will also convert at $3.00 per share.

Uncapped notes are great for founders. Investors are giving you money today at a future price. Investors agree to these founder-friendly terms to guarantee a spot in your next round.

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How do MFNs convert?

"MFN" means "most-favored nations" and can be identified with the following paragraph in the standard YC SAFE form and occasionally requested in separate side letters by investors:

MFN means that if you sign a SAFE anytime after the SAFE with an MFN, you have to inform the investor of the terms of that SAFE so that they can decide if those terms were better. For example, you may have given an MFN to an investor at a valuation cap of $10 million. If you later enter into a SAFE with a valuation cap at $9 million, the investor can require you to amend their SAFE and change their valuation cap to $9 million as well.

What founders miss is that valuation is not the only term that matters. MFN can apply to any term. If you initially raise on post-money SAFEs, and then use a pre-money SAFE, the investor with an MFN can choose to convert their SAFE to pre-money (unlikely but allowed). If you give an MFN to an investor at a valuation cap of $10 million and later give another investor a valuation cap of $10 million and a discount rate, then the MFN investor can demand that they receive the discount rate as well.

MFNs make calculating dilution more complicated. An MFN is like the rainbow card in Uno. You can swap it out for any other term. When you change one term on a cap table, it can affect the ownership of all other investors.

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How do pro-rata rights convert?

Pro-rata gives investors the right, but not the obligation to invest in your next round to maintain their ownership. Read our section on series A fundraising to understand how pro-rata affects your round. First, let's start with definitions:

In layman's terms, pro-rata means that your investor who owns 5% at the seed stage can purchase more shares at the series A to maintain their 5% ownership.

The following is how you calculate the pro-rata allocation:

  1. Determine an investor's percentage ownership before the series A - This is the investor's ownership before your series A investor receives shares and before you increase your option pool.  Follow the steps above to determine the percentage ownership.
  2. Determine an investor's pro-rata allocation - the pro-rata allocation is the amount of funding an investor can add in the new round. For example, Bob Jones owns 5% of Acme Paper at the seed stage. Acme raises a $10,000,000 on a $50,000,000 valuation for their series A. Bob's pro-rata allocation is  $500,000 (5% * $10,000,000). To maintain his 5% ownership in Acme, bob needs to purchase $500,000 worth of shares. The logic behind this math is that Bob will be diluted at these series A. To counter the dilution, Bob should just purchase more shares at the series A.
  3. Determine the price of pro-rata shares - Pro-rata shares are the same as the price of shares for your series-A investor. Pro-rata doesn't give investors a discount on your series-A. It just gives the right to purchase more shares at the same price.
  4. Calculate the number of pro-rata shares - This is the number of shares of the new round allocated to the pro-rata investor. Pro-rata shares = Pro-rata Allocation ($) / Price of Pro-rata Shares ($).

Series A fundraising - common misconceptions

Founders describe an equity round as $X raised on a $Y pre-money valuation. A common misconception is thinking of this $X as the amount of funding your lead investor contributes. This is not correct. The $X amount raised at the series A is the total funding by your new series-A lead investor AND funding from pro-rata contributions by your existing investor.

Dilution at the series A is ~20%. One standard approach is that the lead investor gets half of the round and targets ~10% ownership. The remainder goes towards pro-rata allocations and new investors to close out the round.

Ex:

Acme raises $20m on a $100m pre-money valuation.

Here's what the series A funding would look like:

  • Money Ventures (lead investor) contributes $15m
  • Harry Adkins is a seed investor and owns 10% at the seed stage. He can purchase 10% of the series A funding round (10% * $20m investment = $2m)
  • Other new investors finish out the round and contribute $3m

The total amount raised is $20m. Harry's pro-rata rights are counted within this $20m.

If your company is doing well, investors will fight to have a bigger piece. Even though pro-rata is included in the terms, many good investors care about maintaining a long-term relationship with you and will be flexible on taking less of their pro-rata.

How do most startups model dilution?

Many startups use a spreadsheet that depends on iterative calculations. You can ask for the latest model from the YC finance team. Another option is to model ownership is to use Pulley's pro-forma modeler. We handle the cases of pre-money SAFEs, post-money SAFEs, YC's participation rights, pro-ratas, option pool increases, and modeling for rounds beyond the series A. We've tested this against hundreds of companies so you can be more confident the numbers are correct.

Pro-tip: Math mistakes are expensive. An extra few shares if you're the next unicorn can be meaningful. Even if you're working with an expensive lawyer, double-check the math. The mistakes we've seen include using the wrong basis for calculation (pre-money math on a post-money SAFE), not including a SAFE note holder in the recursive calculation, or logical errors from improperly implementing the recursive functions.