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When starting your company, chances are the first things you think about are the problem you’re solving, your potential customers, the product and a whole host of mission critical tasks. While that should rightfully be your focus, another area you shouldn’t overlook is the importance of properly setting up your company’s capitalization table (cap table) and equity issuances.

This is a topic I’ve spent many long hours walking through with founders, oftentimes when an important point was skipped along the way, or when there’s an imminent financing that would be held up without a clean cap table. In my time as a venture lawyer with one of the leading firms in the industry and a pre-seed investor with the most active fund in the world, I’ve reviewed quite literally thousands of examples of these.

Below we’ll walk through some best practices and market norms when it comes to cap tables and equity issuances from formation to your first priced funding round. This isn’t meant to be legal advice or a technical guide like you might find from, for example, Cooley LLP’s GO resource, but rather it’s meant to be a complementary article that helps you avoid common mistakes that can cause anything from headaches and legal fees to disagreements over ownership.

Starting out

Nowadays many first-time founders do an initial incorporation online. There’s a few well-known options for this, as well as experienced law firms that provide online generators or free/discounted incorporation services. Fully automated options can be OK but don’t have the nuance of a lawyer, so there are some issues that can arise at this stage if not careful. The most common in my experience are technical mistakes with the initial share purchase and choices around vesting.

On the first point, it is critical for founders to complete the technical purchase of their initial shares. That means signing the legal docs, and usually writing a small check to purchase the shares at or near par value. If this isn’t done at incorporation, it can lead to tax consequences for founders when they start building and raising money without having completed the purchase. It happens more than you think, and I’ve seen cases where the fair market value of the shares rose due to revenue and SAFE financings and founders had to purchase their initial shares for much more than par value to avoid tax issues.

If in the US, the other absolutely critical point is for each founder to file Form 83(b) with the IRS within 30 days of purchase if you have shares with vesting (which is a good idea, explained below). It must be filed within that time or it can cause massive future tax liability and will often be checked in diligence, so there’s not much else to say other than to get it done!  

With vesting, I get lots of questions from founders if they can forgo this when incorporating, usually because the concept seems odd (earning the equity in your own company?!) or they plan to add it only if asked by investors. However, one key reason to include vesting at incorporation is to keep your own co-founding team aligned. 

Founding teams break up for all sorts of reasons, and vesting makes sure that the scarce resource of equity is only being retained by people still working on the company. With the proliferation of early-stage financing using SAFEs, founding teams might make it years without an investor requirement for vesting and a cofounder dispute over a large portion of the equity at that point could kill the company’s prospects.

Signed legal documents should be in hand before any line item appears on your cap table, so now that the initial shares are issued you can create the first version. At this stage, it’s likely nothing more than a ledger of founder and early employee names and the class and amount of shares held.

Raising money on SAFEs / convertible instruments

The tricky thing about cap tables these days is that the most common fundraising documents for a seed round have changed in the past 10 years. While convertible notes and SAFEs (we’ll broadly call them all SAFEs for the rest of this post as that is most common in the US) were previously used for a small amount of early investment, companies now use these for more capital and often in successive rounds up to a Series A. This isn’t necessarily a bad thing, but makes decoding early stage cap tables and ownership trickier than a priced equity round. For founders, the key is to understand how much equity is being sold and to make sure you don’t overdilute and hurt future prospects. 

SAFEs turn into shares in the future so it’s not necessarily possible at the time of issuance to know exactly how much dilution the founders will take. It’s critical for anyone raising money using a SAFE to know how that future conversion to shares will work as the SAFE forms come in many varieties and handle this differently. The most common these days is called a post-money SAFE, which you’ll find on the YC website along with helpful content on its use. 

One particular term to be very careful about is called most favored nation (MFN). When granting an MFN to an investor, it means that any future deals given at a better price will adjust the existing agreement with that investor to the new lowest price. If you have many SAFEs or a large investor with an MFN this can have a huge effect. 

For founders the main thing to realize is that when the investments on the standard SAFE convert, it will be at the valuation cap on your SAFE or lower, regardless of the valuation of your next round. This can get tricky to keep a mental gauge on if you raise at various times with different valuation caps, so if raising significant capital on a set of SAFEs I always recommend consulting with an attorney and preparing what’s known as a pro forma cap table. 

A pro forma is a version of your standard cap table that includes calculations modeling the change in ownership that will take place after a financing round. When doing this for a set of SAFEs you’ll have to make assumptions about your future priced round and option pool in order to get an accurate projection.  

When doing this rough calculation, there isn’t a hard and fast rule to how much dilution is acceptable at each stage of a company’s financing, but market norms for early stage rounds tend to land around:

• 5-15% for a pre-seed round (if you do one)
• 15-25% for a seed round
• 15-25% for an A

If doing your pro forma or back of the envelope analysis would push you meaningfully beyond these thresholds, that’s a sign you should probably think carefully about how the funding round would affect the company in future.  

Too much dilution at too early of a stage can be a real wrench in getting a new round of financing done. I’ve seen several founders have to go back to early investors to try to renegotiate the terms of their SAFE because the conversion would give them a disproportionate ownership of the company,  leaving too little equity remaining to properly incentivize the team and allow for future financing. At that point, companies are often stuck having to alienate early backers or risk losing new investor interest, a very uncomfortable place to be. Best to avoid the situation if possible and try to stick relatively within the range of equity outlined above. 

Issuing options and advisor shares

Other than initial founder stock and issuing SAFEs, the next time any changes to an early-stage cap table are likely to happen is when issuing shares or options to early employees and/or advisors. The most common way to do this is to issue either restricted shares just like the founders hold or to set up an option plan. At this point you likely should be working with an attorney unless this post is all old news to you.

Common questions I often hear on this topic are how large to make the option pool, what needs to be done before issuing options, and what the right size of grants for advisors should be. 

Deciding on the size of an option pool can be deceptively difficult. In absolute numbers it is rare to have an early option pool that exceeds 10-15% of the company capitalization. However, when choosing it’s best to keep in mind that both timing of its creation and size of the option pool matter for founder dilution. 

In the standard post-money SAFE, any option pool existing before the conversion of the SAFE only dilutes the initial stockholders, whereas an increase or formation of the option pool in connection with the future priced equity round dilutes both the founders and SAFE investors equally. This means that if a founder set up a larger option pool than actually needed (say 10%), and only ended up issuing options for half of that amount before the conversion of the SAFEs, the founders would still be diluted by the full 10%. So, to limit dilution, founders who will be raising funds on post-money SAFEs should likely keep their option pool as small as necessary for early employees until their SAFEs convert. 

Assuming you’ve now set up your option pool and are getting set to issue options to your early employees, there’s one other critical thing to complete before that can happen: a 409A valuation. This is a third party valuation of the fair market value of a company’s common stock, and it is needed to determine the price at which options will be granted to employees. Failure to do this before issuing options could open up the employees to tax bills and uncertainty, as any discount below fair market value would be considered income. 

Now that you have both the plan set up, and a 409a valuation in hand, it’s finally time to make grants to your early employees or advisors. This is when questions often turn toward benchmarks for how large a grant should be. 

For early employees, the amounts often differ depending on things like the role, seniority, incentivization needed to recruit the candidate and existing size of the founding team. Given the multitude of factors it is hard to provide one-size-fits-all advice and is best to correspond with your investors, recruiters, or lawyer for up-to-date benchmarks. 

However, when it comes to advisors, there is a much narrower common range for grants. A standard rule of thumb might be: no more than 0.2% for a general advisor (and likely less), 0.5% for a rare advisor who is heavily involved and providing critical help, and no more than 1% for someone who is a true luminary in the field. As early-stage valuations have risen, we often see investors asking for additional advisory shares to drive down their overall cost of investment. As you can see from the ranges outlined, this is a practice we generally recommend avoiding or limiting to very small grants. 

Early choices with long-term implications

From company founding to your first priced round of financing, there are many choices to be made about your equity structure that will have big implications as the company grows.

Hopefully the points outlined above can help you think through some of the most common issues that arise when forming your company, raising your first investments and giving equity to your earliest employees and advisors.