How was the company financed?

Very early employees need to ask about a specific detail regarding a company’s financing to properly assess an offer

You just got an offer as the first engineer at a recently created startup working on your dream technology problem with great people. Congrats! You probably got an offer where your compensation was expressed as some mix of cash and equity.

A specific detail about how the company was financed can make a big impact on what your equity may be worth. Most founders and investors miss out on the consideration of this important detail. But as an early employee you have a lot to gain or lose by being equipped with this knowledge.

In order to understand this we’ll do a quick primer on dilution. Dilution is a concept in finance where a company issues new shares, thereby reducing the fraction of the company any given share represents. Each share is diluted by the same amount. Usually this is done so that the new shares can be sold to investors or awarded to new employees who are joining – hopefully this helps grow the company faster (more resources!). You may receive a grant for 1% of the equity of the company at the time you join. But as subsequent rounds of financing are raised your ownership percentage is being reduced as the pie is hopefully growing. At IPO you might only own 0.5% or less, but the value of the overall company has increased so what you own in dollar value is worth much more than what you owned when you were granted the initial 1%. Now let’s get to the specific details that everyone forgets to discuss.

About a decade ago Y Combinator created a new financing document called the SAFE (“Simple Agreement for Future Equity”). It was designed to fix a few bugs present in convertible debt which was a related financing instrument commonly used prior to the creation of the SAFE. This document is a whole lot simpler than raising money by selling equity. In a SAFE the dilution is understood, but has not actually been calculated into the cap table (the record of ownership by existing shareholders). For the purposes of example we’ll say that the company you’re joining has raised $2m on a $10m post-money SAFE. The founders have in mind that they are going to be diluted 20% for that $2m SAFE, but that will help them hire and build the company so it’s a worthwhile trade.

Say you’re joining as an engineer after the SAFE has been executed, but before the company has raised a priced equity round (e.g. a “series A”). A year after you join, the company raises a series A (woo-hoo –  things are going great!). In this example we’ll say the series A is $10m on $40m pre-money (a.k.a. $50m post-money valuation). This amounts to 20% dilution of all existing shareholders. You would expect your shares are diluted by the new priced equity. However, you may be surprised to learn that you will additionally be diluted by the financing that occurred before you even joined. Ideally you’re only being diluted by events that happen after you join, but the SAFE creates a form of “hold-over dilution” from stuff that happened before you joined. In this example your 1% would be diluted by 20% from the SAFE and then an additional 20% from the series A. Meaning after the series A you’ve been diluted down to 0.64%, whereas you may have thought you had only been diluted down to 0.8%.

So how do you get around this? Ask about the terms of the financing and ask if it was done via SAFE or priced equity. If the company was financed by a SAFE (or multiple SAFEs!) that hasn’t yet converted to equity, point it out to the founder and ask for a true-up on the equity offer. e.g. instead of 1%, maybe you should get 1.25% so that the SAFE which occurred before you joined will dilute you back down to the 1% that you’re discussing. And the series A will then dilute you by an additional 20% so you’ll be at 0.8% after that.

There’s no perfect answer for how much equity a new/early employee should receive as part of a compensation package. But you should have a full understanding of the cash/stock that the offer includes so that you’re equipped to properly evaluate (or further negotiate) the offer.

I’ve run into two people in the past week who’ve been bitten by this bug. One while she was evaluating an offer and one after he’d already joined the company and learned about this detail. Figure it out early, raise it as a concern, and improve your ability to evaluate and negotiate your equity compensation.

For more thoughts on negotiating equity compensation take a look at this article I wrote on the topic.