Cap Table & Startup Equity Definitions: Complete Reference Guide

This comprehensive startup equity reference guide covers essential cap table definitions to help you as a founder, entrepreneur, team member, or investor navigate equity structures and fundraising.

If there's a term in a definition that you're unfamiliar with, search for the term as it's likely defined elsewhere in this guide. Many terms are linked to related concepts for easy navigation.

1. Foundations

This section establishes the legal and conceptual infrastructure of cap tables. These are the foundational documents and entities that govern equity ownership and company structure. Start here to understand what a cap table is and the legal framework it operates within.

Cap Table/Capitalization Table

• Document showing company's complete ownership structure at a point in time
• Essential cap table contents: all stakeholders, share classes, ownership percentages (basic and fully diluted), option pool, convertible securities
• Professional cap tables show both basic and fully diluted ownership
• Cap tables must be updated after each equity event: funding rounds, option grants, exercises, conversions
• Accurate cap table management becomes critical before fundraising, hiring, or exit events

Charter/Corporate Charter

• Legal document establishing company's structure, authorized shares, and basic rules
• Defines share classes, rights, and restrictions
• Must be amended to increase authorized shares

Articles of Incorporation

• Formal document filed with state establishing the company's legal structure
• Contains: company name, purpose, authorized shares by class, initial directors
• Must be amended to increase authorized shares or change share class rights

Board of Directors

• Group overseeing major company decisions and setting strategic direction
• Typical composition: founder seats, investor seats, independent seats
• Fiduciary duty to all shareholders, not just appointing party
• Frequency: Usually meets monthly or quarterly

Shareholder Agreement

• Legal document outlining rights, obligations, and equity rules among shareholders
• Covers: voting agreements, transfer restrictions, drag-along/tag-along rights, ROFR
• Binding on all shareholders who sign

Cap Table Audit

• Comprehensive review of all equity grants, conversions, share counts, and supporting documentation to identify cap table errors or risks
• Common cap table audit findings: missing 83(b) elections, incorrect option strike prices, inaccurate conversion calculations, missing stock certificates
• Critical before fundraising or acquisition to avoid deal delays caused by cap table discrepancies

2. The Core Math

Understanding share counts and valuations is fundamental to cap table literacy. This section covers how companies count shares, calculate valuations, and measure ownership percentages. Start here if you need to understand dilution or verify cap table calculations.

Authorized Shares

• Maximum number of shares a company is legally allowed to issue as defined in corporate charter
• Typically much larger than issued shares, providing room for growth without charter amendments

Basic Shares Outstanding

• The number of shares currently issued and held by shareholders
• Includes common and preferred shares that are actually issued and owned
• Excludes unissued authorized shares, treasury shares, and potential future shares

Treasury Shares

• Shares the company has repurchased from shareholders and holds itself
• Do not have voting rights and are not included in shares outstanding
• Can be reissued or retired by the company

Fully Diluted Shares

• Total shares that would exist if all convertible securities, stock options, and warrants were exercised today
• Formula: Basic shares outstanding + unexercised granted options (vested & unvested) + unallocated option pool + convertible securities (on as-converted basis) + warrants
• Key point: Includes unvested options and reserved pool shares; excludes authorized shares
• Shows true economic ownership percentages and potential dilution

Pre-Money Valuation

• Company's estimated value before new investment round
• Formula: Post-money valuation minus investment amount
• Used to calculate share price: Pre-money valuation ÷ pre-money fully diluted shares

Post-Money Valuation

• Company's estimated value immediately after investment round
• Used to determine investor ownership percentage
• Formula: Pre-money valuation + new investment amount
• Note: Two calculation methods exist for Priced Rounds and SAFEs: "Traditional" (option pool from pre-money) vs "Post-Money" (YC 2018+ SAFEs, pool included in post-money). A "$10M post-money" deal can mean different founder dilution depending on method used

Price Per Share (PPS)

• Cost to purchase one share, calculated using fully diluted share count
• Calculation: Pre-money valuation ÷ pre-money fully diluted shares
• Same price applies to new investors and any simultaneous option exercises or warrant conversions
• Note: This investor price is typically much higher than Fair Market Value (FMV)

Fair Market Value (FMV)

• Conservative estimated price per share for tax compliance and option grant purposes
• Determined by independent 409A appraisal, required annually for private companies
• Typically 30-70% lower than investor pricing in funding rounds due to illiquidity, risk factors, and IRS scrutiny
• Used exclusively for setting employee option strike prices, NOT for investor pricing
• Example: Company raises Series A at $5/share, but 409A FMV might be $1/share for option grants

409A Valuation

• Independent appraisal of fair market value required by IRS Section 409A for stock option compliance
• A 409A valuation is generally considered valid for 12 months unless a material event occurs (such as a new financing round, a major acquisition, or a significant change in financial outlook)
• It must be updated at least annually OR after any material event, whichever comes first, by qualified independent appraiser
• Non-compliance triggers severe penalties: immediate taxation of deferred compensation plus 20% penalty tax plus interest
• Provides "safe harbor" protection from IRS challenge if done properly

Ownership Percentage

• Proportion of company owned by each stakeholder
• Calculation: (Shares owned ÷ fully diluted shares) × 100
• Always calculated on fully diluted basis in professional contexts

Dilution

• Decrease in ownership percentage resulting from new shares issued or converted
• Crucial consideration when planning funding rounds and employee hires
• Important: Ownership percentage decrease doesn't mean loss in value. Example: You own 100% of company worth $1M ($1M value). Raise $1M at $9M pre-money valuation → you own 90% of $10M company ($9M value). You're diluted from 100% to 90%, but your stake increased 9x in value

Down Round

• Financing at a lower price per share than the previous round
• Triggers dilution and sometimes anti-dilution protection clauses
• Note: Based on price per share, not total valuation. A company can raise at higher valuation but still be a down round if share count increased significantly

Weighted Average

• Method of calculating average share count over a time period
• Required for earnings per share calculations and some anti-dilution provisions
• Accounts for timing of share count changes during reporting periods

3. Equity Instruments

This section defines all the different types of securities that appear on cap tables. Understanding the distinction between share-based instruments (equity you own today) and convertible instruments (rights to future equity) is essential for accurate cap table modeling.

3.1 Share-Based Instruments

Share Class

• Categories of stock with different rights and privileges
• Common types: Common stock, Series A/B/C preferred, founder preferred
• Voting rights may vary by class, affecting control and governance

Common Stock

• Basic equity ownership with voting rights but lowest liquidation priority
• Typical holders: founders, employees, sometimes early investors
• Preferred stock often converts to common stock on exit

Preferred Stock

• Equity security with special rights and preferences over common stock
• Key features: liquidation preference, anti-dilution protection, board representation, protective provisions
• Typically converts to common stock for fully diluted calculations

Majority Shareholders

• Shareholders owning more than 50% of voting shares
• Have control over major company decisions and can trigger drag-along rights
• Note: SAFE and convertible note holders are not yet shareholders (they hold debt/future equity rights). Majority shareholders are typically founders until a priced equity round.

Minority Shareholders

• Shareholders owning less than 50% of voting shares
• Protected by tag-along rights and other minority protections

3.2 Convertible Instruments

Convertible Securities

• General term for instruments (like notes or SAFEs) that convert into equity upon a future event

SAFE Notes (Simple Agreement for Future Equity)

• Investment instrument that converts to equity in future financing rounds
• Unlike convertible notes, SAFEs are not debt instruments and have no interest accrual or maturity date
• Developed by Y Combinator as simpler alternative to convertible notes
• Key terms: valuation cap, discount rate, MFN, conversion triggers
• Dilution calculated by estimating conversion shares based on cap and discount scenarios

Post-money SAFE

• SAFE variant (introduced by Y Combinator in 2018) where the investor's ownership percentage is fixed at the time of investment
• Ownership formula: Investment Amount ÷ Post-Money Valuation Cap = Ownership %
• "Post-money" means the cap includes the SAFE investment itself, so a $500K investment at a $5M post-money cap yields exactly 10% ownership at conversion
• Key benefit: Predictable dilution for both founders and investors; no complex calculations needed at conversion
• Multiple post-money SAFEs convert simultaneously without diluting each other; each SAFE's ownership is calculated independently against the same pre-conversion share count
• Note: This is now the standard SAFE structure (~85% of SAFEs issued). Assume any SAFE issued after 2018 is post-money unless explicitly stated otherwise

Pre-money SAFE

• Original SAFE structure (Y Combinator 2013–2018) where the valuation cap excludes the SAFE investment amount
• Ownership depends on other SAFEs and the option pool size at conversion, making dilution harder to predict
• Multiple pre-money SAFEs can dilute each other during conversion, unlike post-money SAFEs
• Rarely issued today (~15% of SAFEs) but may exist in older cap tables; verify SAFE version before modeling conversions
• If you have both pre-money and post-money SAFEs outstanding, consult legal counsel as the conversion math becomes significantly more complex

Convertible Notes

• Debt instruments that convert to equity under specified conditions
• Principal plus accrued interest converts to shares, increasing total conversion amount
• Convert at the lowest price among: cap price, discounted round price, or round price (whichever gives the noteholder the most shares)
• Example of interest impact: Raise $100K at 8% annual interest. After 18 months, converts as ~$112K worth of equity (principal + $12K accrued interest), not $100K. Founders often underestimate this additional dilution

Warrants

• Securities giving holder the right to purchase shares at specific price within set timeframe (typically 5-10 years)
• Common uses: issued to investors, lenders, or service providers as additional compensation
• Similar to options but typically longer-term with different tax treatment
• Key difference from options: Warrants dilute all shareholders when exercised, while options come from pre-allocated pool

3.3 Key Conversion Mechanics

Conversion Ratio

• Number of common shares received per preferred share upon conversion (when preferred stock is exchanged for common stock)
• Can adjust based on anti-dilution provisions in subsequent financing rounds
• Most preferred stock converts to common stock on IPO or acquisition

Valuation Cap

• Maximum valuation at which convertible securities (SAFEs, convertible notes) convert to equity
• Protects early investors by ensuring they receive more shares if company valuation increases significantly
• Conversion mechanics: Investor converts at the lowest price (most favorable to investor, resulting in more shares):
  1. Price derived from the valuation cap:
     • Traditional/Pre-money SAFE or Note: Cap ÷ pre-money fully diluted shares
     • Post-money SAFE (YC 2018+): Calculated to ensure investor owns (Investment ÷ Post-Money Cap) % of company
  2. Next round's price per share with discount rate applied (if discount exists)
  3. Next round's price per share (if no cap or discount exists)
• When both cap and discount exist: Both option #1 and #2 are calculated, and the lower price is used automatically
• Common misconception: Investors don't "choose" between cap and discount. Both are calculated, and the most favorable price is automatically applied

Discount Rate

• Percentage reduction from the next round's price offered to holders of convertible securities
• Compensates early investors for their risk by giving them a better price than later investors
• Common range: 15-25% discount (e.g., 20% discount means paying 80% of next round's price)
• When both a cap and discount exist, the investor converts at whichever mechanism yields the lower price per share (more shares for their investment)

Equity Financing

• Any bona fide priced round that triggers automatic conversion of SAFEs into preferred stock
• Unlike Qualified Financing for convertible notes, SAFEs have no minimum threshold; any priced equity round triggers conversion
• Defined in YC SAFE documents as: "a bona fide transaction... pursuant to which the Company issues and sells Preferred Stock at a fixed pre-money valuation"
• This is why SAFEs are simpler than convertible notes: no threshold negotiations, no maturity dates, automatic conversion on any priced round
• Note: "Equity Financing" (capitalized) is a SAFE-specific defined term. Generic "equity financing" simply refers to any fundraising in exchange for equity

Qualified Financing

• Funding round meeting minimum requirements to trigger automatic conversion of convertible notes
• Typical threshold: $1,000,000–$2,000,000 in new equity financing (excluding amounts from converting notes), though varies by agreement
• Purpose: Prevents "manufactured" conversions from trivially small investments
• If a round falls below the threshold, see Non-Qualified Financing for conversion options
• Note: SAFEs use different terminology and have no minimum threshold, see Equity Financing

Non-Qualified Financing

• Equity financing that falls below the Qualified Financing threshold
• The convertible note remains outstanding as debt; noteholders may have optional (not automatic) conversion rights into the preferred stock sold in that round
• Majority holder provision: If holders of a majority of outstanding note principal elect to convert, their decision may be binding on all noteholders
• Converting holders receive the same rights and obligations as investors in that financing round

Most Favored Nation (MFN)

• Provision guaranteeing an investor receives terms at least as favorable as any subsequent investor
• As a SAFE provision: If the company issues later SAFEs with better terms (lower cap, higher discount), the MFN holder can elect to upgrade their SAFE to match those terms (typically within 10 days of notification)
• As a standalone SAFE type (Uncapped MFN SAFE): A YC SAFE variant with no valuation cap and no discount, only MFN protection. Used for very early investors when founders cannot yet justify a specific cap
• MFN only applies to subsequent SAFEs, not to priced equity rounds
• Common misconception: MFN doesn't guarantee the investor gets the best terms of all investors; it guarantees they get terms at least as good as later SAFE investors

4. Employee Equity

Employee equity compensation is a critical component of startup culture and cap table management. This section covers how companies grant equity to team members, the tax implications, and the mechanisms that govern when equity is earned. Essential reading for both employers and employees.

Grant/Equity Grant

• Issuance of equity, options, or other equity instruments to a stakeholder
• Common types: stock option grants, RSU grants, restricted stock grants
• Typically subject to vesting schedules and other conditions

Employee Stock Option Pool (ESOP)

• Shares reserved for future employee equity grants
• Typically allocated at 10-20% of fully diluted shares for early-stage companies
• Usually carved out of founder shares before investor rounds (often expanded at each financing via option pool shuffle)

Stock Options

• Rights granted to employees/advisors to purchase shares at a predetermined price
• Count toward fully diluted shares even when unvested or unexercised
• Key terms: strike price, vesting schedule, expiration date

Strike Price/Exercise Price

• Price option holder pays to convert option to actual share
• Once granted, strike price remains fixed. If the company's share value rises over time, you benefit by exercising at the lower strike price
• Must equal or exceed FMV at grant date per 409A requirements

83(b) Election

• Tax election filed with IRS within 30 days of receiving unvested shares
• Allows taxpayer to pay tax on the equity's current (low) fair market value at the time of grant, instead of paying tax on a potentially much higher value later when the shares vest
• Applicability:
  • Applies to: Restricted Stock (RSAs) and Early-Exercised Stock Options (filing on the unvested shares you receive upon early exercise, not the option itself), because in both cases you receive actual shares (property) that are still unvested
  • Does NOT apply to: Standard vested options (shares are already vested when you receive them) or RSUs (you don't receive property at grant, only a promise)
• Critical for founders and early employees: missing the 30-day deadline cannot be corrected
• Example: Receive 1M restricted shares worth $0.001/share ($1K value). With 83(b), pay tax on $1K now. Without it, pay tax on potentially millions when shares vest

RSUs (Restricted Stock Units)

• A promise from a company to grant shares at a future date, subject to vesting
• Key Difference: Unlike Restricted Stock (RSAs), no property is transferred at grant. You are not a shareholder and have no voting rights until the RSUs vest and the shares are delivered
• Taxation: Because you don't receive property at grant, an 83(b) election is not applicable. RSUs are taxed as ordinary income at the time of vesting, based on the value of the shares when you receive them, with no ability to accelerate taxation via 83(b)
• No purchase price required upon vesting

Advisor Shares

• Typically stock options, restricted stock, or warrants granted to strategic advisors in exchange for guidance and expertise

Vesting

• Process of earning ownership of stock or options over time
• Standard schedule: 4-year vesting with 1-year cliff for employees
• Unvested shares still count toward fully diluted share count

Cliff/Cliff Vesting

• Initial period where no shares vest; all-or-nothing vesting after specific time
• Protects company if employee/founder leaves early
• Standard terms: 1-year cliff, then monthly or quarterly vesting

Acceleration/Vesting Acceleration

• Speeding up vesting schedule due to specific events
• Types: single-trigger (company sale) or double-trigger (sale + termination)
• Affects timing but not total fully diluted calculation

Option Pool Shuffle

• Process of expanding the employee option pool, often before fundraising
• Creates asymmetric dilution: when pool is carved from pre-money valuation (standard), founders bear the full dilution while investors maintain their target ownership percentage
• Example: VC wants to invest $5M for 25% with 20% option pool. If pool created pre-money, founders dilute from pre-pool % to accommodate both investor and pool

Slicing Pie Model

• Dynamic equity split framework (Slicing Pie) based on actual contributions over time, not just roles or timing
• Contributions valued using "fair market value" multiplied by risk multiplier
• Adjusts equity split as people join/leave or contribution levels change
• Alternative to fixed equity splits at founding

5. Investor Rights & Process

This section covers the fundraising process and the rights investors receive in exchange for their capital. Understanding these terms is critical for founders negotiating term sheets and for investors evaluating investment opportunities.

5A. Investment Process

Angel Investor

• Individual who invests personal capital into early-stage startups, typically during pre-seed or seed stages before institutional venture capital firms enter
• Investment size: typically $10,000-$250,000 per investor; angel rounds often raise $100,000-$300,000 from multiple angels
• Provide mentorship, connections, and strategic guidance in addition to capital
• Less formal structure than VCs, typically less intense due diligence, and often negotiate directly with founders and may use SAFEs or convertible notes
• Cap table impact: Angel investments typically result in 10-20% dilution but are often essential first external funding

Limited Partners (LPs)

• Institutions and wealthy individuals who provide capital to venture capital funds, delegating investment decisions to General Partners and don't participate in day-to-day management
• Common LP types: pension funds, university endowments, insurance companies, foundations, family offices, sovereign wealth funds
• LPs don't appear on startup cap tables directly (the VC firm owns the equity), but LP return expectations influence VC fund timelines and startup strategy

General Partners (GPs)

• Senior managers and decision-makers at venture capital firms who select investments and manage fund operations
• Source deals, conduct due diligence, negotiate terms, sit on portfolio company boards, guide strategy
• When a VC firm invests, the GP represents the firm on the startup's cap table and typically holds a board seat

Venture Capital (VC)

• Institutional investment firms that deploy pooled capital from Limited Partners into high-growth companies in exchange for equity stakes
• Investment size is typically $1M-$10M+ per investment, significantly larger than angel investors
• Fund seed through growth stages (Series A-D), though firms often specialize in specific stages
• Take active involvement with startup with board seats, strategic guidance, operational support through board representation
• 5-10 year fund lifecycles; investments held until exit via IPO or acquisition

Accelerator

• Short-term intensive program (typically 3-6 months, cohort-based) that provides seed funding, structured mentorship, and investor connections to help early-stage startups scale rapidly
• Highly selective: accept startups with MVP (minimum viable product) and some early traction
• Standard terms: $120,000-$500,000 funding for 5-10% equity stake (Y Combinator: $500,000 for 7% via post-money SAFE), some don't provide funding at all but may still require equity for mentorship and network access
• Cohort structure: batches of startups go through together, culminating in "Demo Day" pitch event for investors
• Key difference from incubators: Accelerators scale existing products through intensive programs; incubators develop ideas through long-term support

Incubator

• Business support organization that provides office space, lab space, mentorship, and resources to help early-stage startups develop ideas and build sustainable foundations, focusing on organic growth rather than rapid scaling
• Typically at the idea to very early stage (may not have MVP yet)
• Variable funding: some provide capital, some don't; equity stakes typically 0-5% (lower than accelerators) and thus lower dilution than accelerators but less intensive support and investor network
• Support resources: shared or private working space, equipment, business development expertise (legal, accounting), mentor networks, education workshops
• Key difference from accelerators: Incubators help figure out what to build; accelerators help scale what you've already built

Venture Studio

• Organization that builds multiple startups from inception, acting as both founder and investor by generating ideas internally or partnering with entrepreneurs
• Parallel entrepreneurship: builds multiple companies simultaneously with internal teams and capital
• Extremely high operational involvement: studios are active founders/operators, not passive investors or advisors, and thus the equity stake is usually 20-50%+ because studios function as co-founders with significant operational roles
• Builds companies from idea to seed or Series A stage, then typically transitions to investor role
• Key distinction: Studios build companies with internal teams; accelerators scale existing companies; incubators support idea development

Funding Round

• Discrete fundraising event where company raises capital from investors
• Named sequentially: Seed, Series A, Series B, Series C, etc.
• Each round typically priced at higher valuation than previous (except down rounds)

Priced Round

• Funding round where the company issues equity (typically preferred stock) at a specific price per share
• Establishes company valuation through negotiated pre-money and post-money valuations
• Named sequentially: Seed, Series A, Series B, Series C, etc.
• Triggers conversion of outstanding SAFEs and convertible notes (if qualified financing threshold is met for notes)
• Key distinction from unpriced rounds: Investors receive actual shares immediately rather than a promise of future equity
• Unpriced rounds (SAFEs, convertible notes) are faster and cheaper to close but defer valuation negotiation until the first priced round

Bridge Round

• Short-term financing intended to "bridge" a company to its next major funding round
• Intended to extend runway, reach key milestones to improve valuation, cover costs while closing a larger round
• Typically structured as SAFEs (increasingly dominant) or convertible notes rather than priced equity
• Can be led by existing investors ("inside bridge"), with quick timeframe for closing, or from new investors ("outside bridge")
• Bridge to nowhere: bridge capital fails to deliver progress toward milestones, making subsequent fundraising dramatically harder

Lead Investor

• Main investor in a funding round who negotiates terms and anchors the round
• Typically invests largest check and takes board seat
• Sets terms that other investors follow

Term Sheet

• Non-binding summary of key investment terms, signed before legal documents
• Covers: valuation, investment amount, liquidation preferences, board composition, protective provisions, anti-dilution
• Some provisions (no-shop, exclusivity, expense reimbursement) may be binding
• Reference: NVCA model documents provide industry-standard term sheet templates

Due Diligence

• Process investors use to validate company data, finances, cap table accuracy, legal compliance, and business claims before closing a deal
• Includes: financial audit, legal review, cap table verification, technical assessment, customer references, background checks
• Can take 2-8 weeks depending on stage and complexity

Major Investor

• Shareholder with substantial capital or influence, sometimes qualifying for special rights
• Definition varies by term sheet (e.g., holding $1M+ in shares or 5%+ ownership)

Secondary Sale

• Transaction where existing shareholders sell their shares to new or existing investors
• Company does not receive any proceeds (unlike primary rounds where company raises capital)
• Common scenarios: founder partial liquidity, early employee exits, investor selling to another fund
• Requires company approval via ROFR and may require board approval
• Typically priced at discount to last primary round (20-30% discount common for common stock relative to preferred stock, though can vary based on market demand)
• Example: Founder sells 20% of personal holdings for $2M to new investor at $4/share while company's last round was $5/share

5B. Investor Rights & Protections

Liquidation Preference

• Order and amount of proceeds distributed to shareholders on company sale or exit
• Non-participating preference (1x is standard): Investor chooses between getting their money back (1x = investment amount) or converting to common stock, whichever is higher. This is founder-friendly: investor doesn't get both. Example: $5M invested for 20% ownership, company sells for $50M → investor takes $10M by converting (20% × $50M), not $5M preference, because $10M > $5M
• Participating preference: Investor receives preference amount AND participates in remaining proceeds with common shareholders. Example: Investor puts in $5M for 25% at 1x participating preference. Company sells for $40M → investor gets $5M preference + 25% of remaining $35M = $5M + $8.75M = $13.75M total (34.4% of proceeds despite 25% ownership). Note: In multi-round scenarios, all liquidation preferences are paid first in seniority order before participation begins, which can significantly reduce common shareholder payouts
• Capped participation: Participating preference with maximum total return limit (e.g., 3x investment)
• Determines actual payout in exit waterfall despite ownership percentages

Anti-Dilution Protection

• Provisions protecting investors from dilution in down rounds
• Broad-based weighted average: Adjustment calculation includes all outstanding shares (common, preferred, options, warrants) - most common and founder-friendly
• Narrow-based weighted average: Adjustment calculation includes only common stock outstanding
• Full ratchet: Investor's conversion price adjusts down to match the lower price of subsequent round, regardless of how many shares were sold in the down round (even a single share sold at a lower price reprices all protected shares). Most investor-friendly, rarely used and highly punitive to founders
• Can increase investor share count, affecting fully diluted calculations

Protective Provisions

• Veto rights given to preferred shareholders over specific major corporate actions
• Common provisions requiring investor approval: selling the company, raising debt above certain threshold, changing share class rights, issuing senior securities, amending charter/bylaws, changing board size, paying dividends
• Typically require majority or supermajority vote of preferred shareholders (voting as separate class)
• Purpose: Protects investors from founders making decisions that harm preferred shareholders' economic interests
• Example: Company cannot sell for $10M without Series A investor approval, even if founders and common shareholders vote yes

Pro-Rata Rights

• Investor's right to maintain ownership percentage in future rounds by purchasing their proportional share
• Allows investors to "follow on" and prevent dilution in successful companies
• Not an obligation - investors can choose whether to exercise
• Often tiered: major investors get full pro-rata rights, smaller investors get pro-rata only in certain circumstances

Information Rights

• Investor's right to receive regular financial and operational information about the company
• Standard provisions: annual audited financials, quarterly unaudited financials, annual budget/operating plan, monthly management reports
• May include: access to facilities, ability to consult with management, advance notice of board meetings
• Typically tied to investment size threshold (e.g., investors holding $1M-$2M+ in shares, known as "major investor status")
• Purpose: Allows investors to monitor their investment and make informed decisions about follow-on investments

Redemption Rights

• Right allowing investor to force company to repurchase their shares after a specified period (typically 5-7 years)
• Redemption price: Usually original purchase price plus accrued dividends (if any), sometimes plus interest
• Rarely exercised in practice but provides negotiating leverage in stalled companies
• Company may lack funds to redeem, making this right more theoretical than practical
• Can create pressure for exit or secondary sale in situations where company is profitable but not growing

Board Representation

• Investor's right to appoint one or more directors to the company's board or attend board meetings
• Board seat: Full voting rights on company decisions
• Board observer rights: Can attend meetings and receive information but cannot vote
• Common for lead investors or those investing significant capital
• A director's fiduciary duty is legally owed to the corporation as a whole, not to any specific shareholder group (including the investor who appointed them). This duty requires them to act in the best interests of the entire company, maximizing value for all shareholders.

Drag-Along Rights

• Allow majority (or supermajority) shareholders to force minority shareholders to join in company sale at same terms
• Typically requires 50-80% shareholder approval plus board approval
• Purpose: Prevents small minority shareholders from blocking acquisitions
• Protections: Often includes minimum price threshold, requirements that all shareholders receive same per-share consideration

Tag-Along Rights (Co-Sale Rights)

• Protect minority investors by allowing them to participate in another shareholder's sale of shares to third party
• If founder sells shares to outside buyer, investors can "tag along" and sell proportional shares at same price
• Purpose: Prevents founders from getting liquidity while minority investors remain illiquid
• Example: Founder sells 10% of company to secondary buyer. Investors can sell proportional amount of their shares at same price per share

Right of First Refusal (ROFR)

• Allows company (and sometimes existing shareholders) to purchase shares before they're sold to outsiders
• Creates orderly process for share transfers and prevents unwanted third parties from becoming shareholders
• Typical order: company has first right, then investors, then other shareholders
• Can delay secondary sales but protects against hostile investors

QSBS (Qualified Small Business Stock)

• Tax benefit under IRC Section 1202 allowing exclusion of capital gains on sale of certain startup stock
• Eligible gains: Up to $15M or 10x cost basis (whichever is greater) can be excluded from federal capital gains tax
• Requirements: C-Corp with <$50M in assets at issuance, held for 5+ years, active business (not passive investments), acquired at original issuance
• Tax savings: Potentially 0% federal tax rate vs. 20% long-term capital gains rate = significant wealth preservation on exit
• Example: Founder holds QSBS worth $20M for 5+ years. Could exclude $15M from federal capital gains tax (depending on issuance date), saving ~$3M in taxes

6. Exits & Payouts

This section covers how ownership translates to actual proceeds when the company is sold or goes public. Understanding exit mechanics and distribution waterfalls is essential for modeling realistic outcomes.

Exit

• Event where shareholders sell their ownership in the company
• Common types: acquisition, merger, IPO, or secondary sale
• Triggers conversion of preferred stock and distribution per liquidation preferences via waterfall

Liquidity Event

• Event triggering SAFE payout: Change of Control, Direct Listing, or IPO
• SAFE holders automatically receive the greater of: (1) their original investment amount (cash-out), or (2) the value of shares they would receive upon conversion
• Different from Equity Financing: Equity Financing converts SAFEs into shares for continued ownership; Liquidity Events provide actual payout or exit
• Liquidation priority: SAFE cash-out amounts rank junior to debt, on par with other SAFEs and preferred stock liquidation preferences, and senior to common stock

IPO (Initial Public Offering)

• When company first sells shares to public markets
• Preferred stock typically converts to common stock
• Creates liquidity for shareholders to sell shares publicly

Acquisition

• Transaction where one company purchases another through merger, stock purchase, or asset sale
• Most acquisitions constitute a Change of Control, triggering investor payouts and employee vesting provisions
• Common structures: Merger (companies combine), Stock Sale (buyer acquires shares), Asset Sale (buyer purchases specific assets)
• Purchase price distributed according to liquidation preferences and ownership percentages via exit waterfall
• May be all-cash, all-stock, or combination

Change of Control

• Transaction triggering liquidation preferences and SAFE/convertible note conversion rights
• Defined as any of:
  • Transaction where a person or group acquires more than 50% of voting securities
  • Merger or reorganization where existing shareholders lose majority voting control
  • Sale, lease, or disposition of substantially all company assets
• Constitutes a Liquidity Event for SAFE holders, triggering payout rights
• May trigger vesting acceleration for employees depending on agreement terms (single-trigger or double-trigger)

Waterfall

• Structure for how exit proceeds are distributed among stakeholders based on liquidation preferences, participation rights, and ownership percentages
• Distribution order depends on seniority structure: Standard seniority (most common) pays latest rounds first in reverse chronological order (Series B before Series A). Pari-passu pays all preferred shareholders proportionally. Tiered uses hybrid approach with groups of equal seniority.
• After liquidation preferences, remaining proceeds distributed based on participation rights (non-participating vs participating) and ownership percentages
• Critical for modeling founder returns: same ownership % can yield vastly different outcomes depending on preference stack and seniority

Earnout

• Payments made to sellers post-acquisition, contingent on hitting specific milestones or performance metrics
• Typical structure: upfront payment + earnout payments over 1-3 years
• Purpose: Bridges valuation gap when buyer and seller disagree on company value
• Risk: Payment is contingent - if milestones missed, earnout isn't paid
• Example: $30M upfront + $20M earnout if revenue hits $10M in year 1

Dissolution Event

• Company shutdown or winding up, excluding Liquidity Events like acquisitions or IPOs
• Includes: voluntary termination of operations, general assignment for benefit of creditors, or other liquidation/dissolution
• SAFE-specific term: SAFEs use "Dissolution Event" per YC documents; convertible notes and preferred stock address the same scenario through their liquidation provisions
• Priority order in dissolution: (1) outstanding debt and creditor claims first (including unconverted convertible notes), (2) SAFEs and preferred stock liquidation preferences on par, (3) common stock last
• In practice, dissolution often means insufficient funds to pay all stakeholders in full

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