A startup that sells a share of itself to an investor is making a trade: money now, in exchange for a slice of whatever the company becomes. Nearly everything about startup financing, from the names of the stages to the shape of the legal documents, follows from that trade and from the fact that, early on, nobody knows what the company is worth.
Stages are labels, not rules
Pre-seed, seed, Series A and the rounds after them are conventions, and the dollar amounts attached to each shift with the market, the country and the sector. The general pattern is that each stage asks the company to show more than the one before.
- Pre-seed money backs a team and an idea, often to build a first version of the product.
- Seed money backs early evidence: a working product, first users or customers, signs that people want it.
- Series A usually backs a business with demonstrated traction that now needs fuel to scale something that works.
- Later rounds fund expansion into new markets or products.
Before any of that, many founders use savings, help from family and friends, grants or revenue from early customers.
How the earliest money is documented
Early investors face an awkward question: how to put money in when the company is too young to value sensibly? Two instruments dominate.
A convertible note is a loan that converts into shares in a later round, usually at a discount. A SAFE, a simple agreement for future equity, is not a loan at all. Y Combinator, which created the form in 2013 and maintains the standard version, describes it as a contract giving an investor the right to stock later, with no interest and no maturity date. It does not become stock until the company raises a priced round, at which point it converts, typically into preferred shares.
Two terms decide how much the investor ends up owning. A valuation cap sets a ceiling on the price at which the SAFE converts, rewarding early investors if the company is later valued higher. A discount gives the investor a lower price than new money pays in that round, and Y Combinator notes discounts are commonly 10 to 20 percent. Where a SAFE has both, the investor gets the better of the two.
Dilution, with real arithmetic
Dilution is the fall in an existing owner’s percentage when new shares are issued. Y Combinator’s own example shows how the post-money SAFE keeps the math simple: 500,000 dollars invested at a 6.7 million dollar post-money cap converts to about 7.5 percent of the company, because ownership is the investment divided by the cap. The company’s SAFEs add together, so five SAFEs of 100,000 dollars at a 5 million dollar cap sell 10 percent, not 2.
A simple hypothetical shows how stakes shrink. Two founders each own half of a company. An investor buys 20 percent after the round. The founders now share the remaining 80 percent, so each holds 40 percent. If a later round sells another 20 percent, every existing holder’s stake is multiplied by 0.8: the founders fall to 32 percent each and the first investor from 20 to 16. Employee option pools set aside before a round dilute everyone too.
Owning less of a larger company can be worth more, which is why diluting can be a good trade. The danger is losing track of the total when several rounds and SAFEs pile up, so founders are advised to keep a running calculation.
What investors weigh
Funds differ, but the questions repeat. Is the team capable of executing and does it understand the problem? Is the market large enough for a very large outcome? Does the product solve something better than the alternatives? Is there traction, meaning customers who use it, pay for it and stay? And do the economics work: what does it cost to win a customer, and how much is that customer worth over time? Our guide to the SaaS model explains the standard measures.
Investors also look at how long a company’s cash will last, a question covered in our explainer on burn rate and runway, since a company short of cash negotiates from weakness.
The costs and the alternatives
Outside capital brings pressure to grow fast, a loss of some control and an expectation of an eventual sale or public listing. SAFEs are also junior to debt in a sale or shutdown, as Y Combinator points out. Many sound businesses never take venture money. They fund themselves from revenue, loans or small investments, an approach known as bootstrapping.
Founders considering any round should read the terms closely, model what ownership looks like after each step and take legal advice before signing.
This is general information, not financial, investment, tax or legal advice.
