Pro Forma Cap Tables for Financing Rounds
For early-stage startups looking to raise a pre-seed financing round (usually from either friends and family, angel investors or Micro VCs), the Simple Agreement for Future Equity, or SAFE, has become a mainstream, company-friendly mechanism to complete the financing. (See goodcounsel’s original post about SAFEs, here.)
goodcounsel often proposes or supports the use of the SAFE for pre-seed rounds, which cuts out some of the “convertible note fat,” i.e., it reduces transaction costs and simplifies the deal terms in a more company-friendly vehicle. And, it is still fair to the investors, because it honors the primary reasons investors should be betting on a pre-seed startup: a home run equity play, with a conversion upon an equity round at a discount to the future price per share, but without the accumulation of interest or the hammer of a looming maturity date, not to mention some heavy-handed control terms we’ve seen in investor-friendly convertible notes).
Our purpose here, however, is not to be the 1,001st blog post arguing the merits of the SAFE. Rather, we came across an article entitled “Why SAFE Notes are not safe for entrepreneurs,” and want to emphasize a critical point that the authors make about the danger to entrepreneurs who don’t understand the future dilution and associated difficulty with raising future rounds. As they put it: “It is critically important that VCs understand cap table math; unfortunately, many do not. Similarly, many CEOs don’t realize the impact that multiple SAFE notes at various valuation caps have on the capitalization table and how these notes can negatively impact the financial viability of the company moving forward.”
We would take this a step further: entrepreneurs and VCs who “do the math” without experience in multiple financings often fail to properly tie “the business deal” with the technical legal terms or understand how those terms affect the cap table as future events unfold. Therefore, it is absolutely critical either to (1) have your law firm prepare a pro forma cap table as early in the term-sheet process as possible, or (2) at minimum, ask the law firm to review and provide comments on the pro forma that has been prepared by the principals – before it is agreed upon.
At goodcounsel, we have a keen understanding of the documentation, the pro forma cap table, and the relationship between the two. We can give clients the benefit of our knowledge in a quick and cost-efficient manner, save them future headaches and legal costs, and most importantly, prevent unexpected dilution in the future.