Equity Financing

How equity financing works

Equity financing sells a piece of the company. The buyer receives shares, or a right to receive shares, and their return depends entirely on what the company is eventually worth. There is no repayment schedule, no interest, and no security interest over assets. If the company fails, the investor receives whatever is left after creditors, which is usually nothing. If the company succeeds, the investor participates without limit.

That asymmetry is why equity exists. A company with neither has nothing a lender can price or seize, so the only capital available is capital that accepts the possibility of total loss in exchange for a share of the upside.

The core arithmetic is ownership, and it runs off the post-money valuation.

Post-money valuation = pre-money valuation + new money invested

Investor ownership = new money invested / post-money valuation

New shares issued = existing fully diluted shares x (investor ownership / (1 - investor ownership))

Price per share = new money invested / new shares issued

Everything else about a round is a variation on those four lines. Note the third one: buying 20 percent of the company after the round requires issuing 25 percent more shares than existed before it, because the new shares are part of the new total.

The instruments fall into three groups.

• Priced preferred stock. The full apparatus. The company amends its certificate of incorporation to create a series of convertible preferred stock with a liquidation preference, conversion rights, anti-dilution protection and protective provisions, and the parties sign a stock purchase agreement, an investors' rights agreement, a voting agreement and a right of first refusal and co-sale agreement, all published as NVCA model forms.
• Deferred-price instruments. A SAFE or a convertible note takes money now and sets the price later, at the next priced round, adjusted by a valuation cap, a discount or a most-favored-nation clause. Y Combinator publishes three post-money SAFE forms: valuation cap only, discount only, and uncapped MFN. A convertible note does the same job as debt, with an interest rate and a maturity date.
• Common stock. Rare in outside financings, standard for founders and employees, and the residual claim that everything else sits above.

The securities law frame applies to all of them. Selling stock is selling a security, so the offering must be registered with the SEC or fit an exemption. Private companies use exemptions, most often under Regulation D, built around selling to accredited investors. The SEC's financial tests for an individual are net worth over $1 million excluding a primary residence, or income over $200,000 individually or $300,000 with a spouse or partner in each of the prior two years. An exempt offering generally still requires a Form D notice, and the choice between a 506(b) offering, which prohibits general solicitation, and a 506(c) offering, which permits it but requires verification of accredited status, is a decision for counsel.

Against debt, the comparison is clean. Debt must be repaid on a schedule regardless of performance, carries interest, is often secured and covenanted, and is senior to equity in a liquidation, but it does not dilute ownership and the lender has no claim on upside. Equity is never repaid, carries no interest, is last in line, and dilutes permanently. Venture debt sits between the two: a loan to a venture-backed company, usually secured and often with warrants attached, priced on the strength of the company's equity investors rather than its cash flows.

Worked example

Follow one company through three financings. All figures are hypothetical.

Starting point. Two founders hold 8,000,000 shares. A 2,000,000 share option pool is authorized. Fully diluted shares outstanding: 10,000,000. Founders own 80 percent.

Round one, a SAFE. An angel invests $500,000 on a post-money SAFE with a $10,000,000 post-money valuation cap. Under the post-money form, that check is 5 percent of the company at conversion, and the dilution from it falls on everyone who existed before the SAFE, not on the other SAFE holders. No shares are issued yet; the SAFE sits on the cap table as an outstanding instrument.

Round two, a priced seed. The company raises $4,000,000 at a $16,000,000 pre-money valuation. Post-money is $20,000,000, so new investors take 20 percent. The SAFE converts at its $10,000,000 cap, half the round's $20,000,000 post-money valuation, so the angel's $500,000 buys about 1.6 times the shares the round price would have bought.

Work the shares. The pre-round fully diluted base is 10,000,000. The SAFE converts into 5 percent of the pre-financing capitalization, roughly 526,316 shares on a base of 10,526,316. With a post-financing fully diluted total of about 13,157,895 shares, the new investors receive 2,631,579 shares at $1.52 each. Founders now hold 8,000,000 of 13,157,895 shares, or 60.8 percent, and the angel holds about 4 percent, having converted at $0.95 a share against the round's $1.52.

Round three, a Series A with a pool refresh. The company raises $12,000,000 at a $48,000,000 pre-money valuation, so $60,000,000 post-money and 20 percent to the new investors. The term sheet also requires the pool to be topped up to 12 percent of the post-round company available for grants, taken out of the pre-money. That detail moves real money: the new pool shares are issued before the investment, so existing holders absorb the dilution rather than the incoming investor, and effective pre-money for them is below the stated $48,000,000.

Result. The Series A and the pool top-up out of the pre-money take the founders from 60.8 percent to roughly 45 percent, employees hold 12 percent through the pool, and outside investors the remainder. The company has raised $16,500,000 and owes none of it. Sold for $300,000,000 with all preferred converting to common, the founders' stake is worth about $135,000,000. Sold for $30,000,000, the preferred stock's liquidation preference is paid first, and after $16,500,000 of preference the common holders divide $13,500,000. The same cap table splits very differently depending on exit size, which is what a liquidation preference is for.

Where it shows up

In the term sheet, equity financing appears as the offering terms block: amount raised, pre-money valuation, price per share, the option pool refresh, the security being sold, and then the rights that attach to it. The NVCA model financing documents are the reference point for most United States priced rounds, and a term sheet is drafted to lead into them.

In the certificate of incorporation, the new preferred series is created, and its liquidation preference, dividend rights, conversion ratio, anti-dilution formula and protective provisions are defined. This is the constitutional document; the contractual agreements sit on top of it.

In the stock purchase agreement, the company represents and warrants the state of the business, the investor represents that it is accredited, and the closing mechanics and conditions are set.

In the investors' rights agreement, the investor receives information rights, registration rights and the right of first offer on future issuances. The voting agreement fixes board composition, and the right of first refusal and co-sale agreement constrains founder share transfers.

In a SAFE round, the documents shrink to one form plus an optional side letter. Y Combinator's post-money SAFE defines the Post-Money Valuation Cap and Company Capitalization and converts at the next equity financing; the separate Pro Rata Agreement, if granted, gives the investor the right to buy its pro rata share of the preferred stock sold in that financing.

In regulatory filings, the round appears as a Form D notice of exempt offering filed with the SEC, which is public and names the exemption relied on and the amount sold.

In the company's own records, the round produces board and stockholder consents, an updated capitalization table, a new 409A valuation to support option pricing, and updated stock ledgers.

Common mistakes

Reading price as the only term. Liquidation preference, participation, anti-dilution formula, board composition and protective provisions frequently decide more of a founder's outcome than valuation does, especially in a moderate exit.

Missing the option pool shuffle. A pool increase taken out of the pre-money is dilution borne by existing holders before the new investor arrives, lowering the effective price they receive. Modeling the refresh explicitly is the difference between the stated pre-money and the real one.

Confusing pre-money and post-money SAFEs. Under a post-money SAFE the investor's percentage is fixed at conversion and other SAFEs dilute the founders. Under older pre-money SAFEs, holders diluted each other and the founder's final position was harder to predict.

Treating equity as free because nothing is repaid. Equity is the most expensive capital a successful company raises: 20 percent of a company that later sells for a billion dollars costs two hundred million.

Raising more than the next milestone requires. Extra capital is extra dilution now for optionality later, and it raises the valuation the next round must clear.

Ignoring the securities law step. Selling stock without a valid exemption, or general solicitation in an offering that prohibits it, creates rescission exposure for the company, not just an administrative problem.

Assuming equity and debt are mutually exclusive. Venture debt, equipment financing and revenue-based facilities exist alongside equity and can reduce how much equity a given milestone requires.

Related terms

Equity financing is the counterpart to debt financing, and most early rounds reach it through a SAFE or a convertible note before converting into preferred stock at a priced seed round or series A. Its arithmetic runs on pre-money valuation and post-money valuation and is recorded on the cap table, where the consequence is dilution. The terms attached to the money include liquidation preference, anti-dilution, the option pool and pro rata rights.

Frequently asked questions

What is equity financing?

Raising money by selling ownership in a company instead of borrowing it. The investor receives shares, or an instrument that converts into shares, and is repaid nothing. Their return comes only if the company is later sold, goes public, or pays dividends.

What is the difference between debt and equity financing?

Debt is borrowed and must be repaid with interest on a fixed schedule, is often secured against assets, and ranks ahead of shareholders if the company fails, but it does not dilute ownership. Equity is never repaid, carries no interest, ranks last, and permanently transfers a share of the company and usually some governance rights to the investor.

Which is better, debt or equity financing?

Neither in the abstract. Debt is cheaper for a business with predictable cash flows and assets to secure, because the lender's upside is capped and so is their price. Equity is the only option when cash flows are uncertain enough that no lender will underwrite them, which describes almost every early-stage company. Many companies use both.

Does equity financing have to be repaid?

No. That is its defining feature. An investor who buys shares has no right to demand their money back; they can only sell the shares to someone else or wait for the company to be acquired, list publicly, or pay a dividend. Redemption rights that would force a repurchase are unusual in venture deals and are resisted by companies.

How much equity should a company sell in a round?

There is no correct number, only a trade. Raise the amount that funds the next set of milestones with margin, then check what percentage that costs at the price on offer. Selling a large share early compounds through every later round; selling too little forces a raise before the company has proof worth pricing.

Who can invest in a private equity financing?

Almost always accredited investors, because private companies rely on exemptions from SEC registration that are built around them. For an individual the SEC's financial tests are net worth over $1 million excluding a primary residence, or income over $200,000 individually or $300,000 with a spouse or partner in each of the prior two years. Certain professional certifications also qualify.