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We Only Have 100 Points of Equity to Split Up

A few years ago I was chatting with one of the first LPs to ever commit to Precursor and I made a statement to him that I think about more and more every day:

At the end of the day, we only have 100 points of equity to split up and that’s not changing.

I have been investing in Pre-seed and Seed-stage companies at Precursor for the past five years and I come back to that conversation all of the time. While I am broadly supportive of all of the innovation that has happened in the early-stage fundraising market, nothing can change the fact that companies only have so much equity to dole out between investors, founders and employees. I’m watching this all play out right now and I’m seeing it cause a lot of heartburn for both founders and investors.

In the last two quarters, I have spent a lot of time dealing with really complicated cap tables and founder and investor ownership issues. Each situation is unique, but they all share some combination of the following characteristics:

  • Many founders need 2-3 rounds of financing to get from idea stage to a meaningful Series A round of financing.
  • This becomes a problem because I believe that most of our fundraising ownership and dilution constructs for venture capital assume smooth fundraising. They assume that you will go from Seed to Series A straight away, maybe with a small Seed Extension needed to get you over the hump. Or, in my world, that you will go from Pre-Seed to Seed to Series A in a straight line. Adding in additional financings, particularly given where we invest, complicates things. Every new investor has a price and ownership threshold that needs to be met in order to get the deal done. If all of these intermediate financings were done on simple terms, this wouldn’t be an issue; but that’s not the case. Many of these intermediate financings are done on SAFEs, where the true dilutive impact of that investment is conditioned on the terms of the next investment. This leads me to my next point.

  • The combination of priced rounds, pre-money and post-money SAFEs, convertible notes and side letters means that neither investors nor founders often fully understand the consequence of the next financing round, who will own what, and how investors will feel about their ownership when the cap table is finalized.
  • In many ways, I feel like this is the heart of the problem. Founders might be able to build pro forma cap tables that reflect what will happen when existing SAFE and noteholders convert. But it is almost impossible to forecast how existing investors will respond to the next round of financing. Will the smaller investors who have pro-rata rights invest? Well, I’ve seen it often depends on the lead; if the lead is a high-profile or name-brand investor, everyone wants to invest whether they have pro-rata rights or not. If the round is dilutive but the company is doing well, many investors will want to invest to keep their ownership levels high. What if the new lead is less well known and offers non-market terms? Well, then all bets are off. Aside from doing the full breakdown of who owns what based on the next round, founders have the unenviable task of figuring out which investors with pro-rata rights will exercise or waive them and which investors who don’t have them will ask to invest. I have yet to see a good way to model this. And in a world where many people have access to SPVs, Opportunity Funds, and outside financing vehicles (including my own fund), managing this becomes really difficult to manage. And, as is the case in most things in venture capital, the most difficult situations arise in the companies with the most investor demand and/or where investor rights are most ambiguous.

    With the benefit of hindsight, I think a lot of the innovation around SAFEs and intermediate financings assumed that both investors and founders would be able to accurately forecast future behavior based on the letter of the law in those documents and some predictability around the next financing. The more investments I make, the less certain I am that this was a good assumption. But we must live with the current reality and find a way forward.

  • We see many founders who are deeply or fully vested by the time they get to a Series A round of financing
  • One consequence of the multiple rounds of financing required to get to Series A financings is that many founders are deeply or fully vested by the time they get to Series A rounds of financing. Given the time and dollars required to get to Series A for some founders, there is a legitimate question around how to balance founder dilution and investor ownership. How much should founders re-vest as a percentage of their ownership? How much dilution should existing investors take to refresh founders and make sure they are properly incentivized to keep working on their companies going forward? Because we only have 100 points of equity to go around, one side’s gain is another side’s loss. And that isn’t changing.

I don’t have a clear answer for how to move forward here, but it is an issue that I am seeing over and over. In the same way that the venture business adjusted to the SAFE (both pre-money and post-money versions), I think we need to develop some new guidance on how to think about founder ownership in the context of multiple financing rounds and lots of other intermediate financings prior to and beyond the Series A. I have been a part of a lot of these conversations with other investors and it feels like many of us are feeling our way towards a new normal in real-time. I worry that without better frameworks to think about and talk about these issues there will be a lot of miscommunication and disconnects in the coming years. I’m very open to hearing about how others are thinking about this.

And, to state an obvious and important point, there are many companies who do have regular, on-schedule financings and skip all of this. This probably doesn’t apply to them. But in a world where there is more capital available, I feel like what I am describing here happens to many founders.