Option pool increase methods

When considering how to adjust your option pool during a financing round, the two primary methods are the pre-money method and the post-money method. These methods influence how the option pool is expanded and, consequently, affect the dilution experienced by both new investors and existing stakeholders.

Pre-money method: This most common method involves increasing the option pool size before new investments are injected into the company. The key advantage is that it shields new investors from dilution due to the option pool expansion. With this method, the goal is to adjust the option pool so that it maintains the desired target percentage after the new investment is secured.
Post-money method: In contrast, this method expands the option pool after the new investment is secured. While this method does lead to new investors facing some dilution due to the expanded option pool, it mitigates the dilution impact on existing stakeholders.
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Example B

Pre-money

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For instance, if your company’s pre-money valuation is $9 million, and you secure a $1 million investment, the resulting post-money valuation is $10 million. Employing the pre-money method, you would increase the option pool before the investment, keeping it at the target percentage. In this scenario, new investors maintain 10% ownership, while existing stakeholders experience a 20% dilution, reducing their ownership from the pre-round 100% to 80%.

Pre-money valuation = $9M
New investment = $1M
Post-money valuation = $10M
Post-round option pool = 10% (pre-money method)
Investor ownership = 10%
Existing stakeholders diluted by 20% to 80% of pre-round ownership

Example C

Post-money

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Imagine a similar scenario with a pre-money valuation of $9 million and a $1 million new investment, resulting in a post-money valuation of $10 million. Using the post-money method, you would adjust the option pool size after the investment. This results in new investors holding 9% ownership, slightly less than Example A above. However, investors now face a 10% dilution due to the expanded option pool, while existing stakeholders experience a 19% dilution, reducing their pre-round ownership from 100% to 81%.

Pre-money valuation = $9M
New investment = $1M
Post-money valuation = $10M
Post-round option pool = 10% (post-money method)
Investor ownership = 9%
Existing stakeholders diluted by 19% to 81% of pre-round ownership

Individual convertible terms

There are three main terms associated with convertibles instruments that are determined at the time of issuance:

Principal: The cash amount that a stakeholder invested in a convertible note that will eventually convert into equity. For example, if the stakeholder invested $10,000, the principal amount is $10,000.
Valuation Cap (optional): Some convertible securities include a valuation cap, which sets a maximum value at which the convertible security will convert into equity, irrespective of the actual valuation of the financing round. The presence of a valuation cap provides a safeguard for investors, ensuring they receive equity at a favorable price.
Conversion Discount: The conversion discount specifies the reduction applied to the price per share when the note holder exercises their right to purchase shares in the subsequent fundraising round. This discount helps early investors secure equity at a lower cost compared to later investors.

These terms play a pivotal role in determining the number of shares issued and the resulting ownership of convertible holders. The calculations for these conversions can vary based on the terms chosen. There are three common methods used to calculate the effective convertible price:

By Valuation Cap (Pre-money Valuation Cap Type): This method is applicable to both convertible notes and pre-money SAFEs. It calculates the convertible price using the valuation cap, considering the pre-money valuation of the company and the option pool increase.
By Valuation Cap (Post-money Valuation Cap Type): Post-money SAFEs utilize this method. It calculates the convertible price with the valuation cap, taking into account the post-money valuation of the company.
Discount: Convertible notes, pre-money SAFEs, and post-money SAFEs can use this method, which calculates the convertible price using the discount rate.

In the end, the calculated convertible price is compared to the price per share for new investors in the round. The lowest price among these options is selected as the effective convertible price:
Convertible Price =	MIN (Valuation Cap Price, Discount Price, Investor Price Per Share)

Valuation cap types

There are two types of valuation caps: pre-money and post-money. The primary difference between the two is how the conversion price is calculated, which plays a significant role in determining the equity allocation during a financing round.

Pre-money
Pre-money instruments are structured in a way that excludes the shares that will be generated upon conversion from the capitalization figure. This means that convertibles in this category convert alongside other pre-money SAFEs and notes. Consequently, it's possible for convertible holders within this group to potentially dilute each other.
The formula employed to calculate the conversion price for pre-money valuation cap types is as follows:
Valuation Cap Price =	Valuation Cap / (Pre-money Fully-Diluted + Option Pool Increase)

Post-money
Named because convertibles of this type convert after other SAFEs and notes have undergone conversion. As a result, post-money SAFE holders are not subject to dilution from other convertibles. In comparison to equivalent pre-money SAFEs, the post-money SAFE structure leads to higher ownership for the holder, but also entails more significant dilution for existing stakeholders.
The formula used to calculate the conversion price for post-money valuation cap types is as follows:
Valuation Cap Price =	Valuation Cap / (Pre-money Fully-Diluted + Total Converted Shares)

Conversion method

The principal, valuation cap, and discount terms for individual convertibles are negotiated at the time of issuance and dictate how an individual SAFE converts in the round.

The Conversion method relates to the methodology agreed upon between the company and investors in a priced round. This methodology determines how the price per share and post-money ownership percentage are calculated. It's crucial to note that while the economics of SAFEs are set at this stage, the question of whether the new investment takes any dilution from the conversion of SAFEs becomes a negotiation point in the financing round.

Carta provides modeling for three conversion methods:

Percentage-Ownership Pre-financing dilution in the round modeling tool
This most common method derives its name from the fixed or pre-calculated percentage ownership of new investors. All other values, including the price per share, are calculated based on this fixed ownership percentage. As a result, convertibles under this method convert in pre-money, meaning they effectively convert before the round concludes. This results in dilution only for the original shareholders, while new investors remain unaffected by convertibles.
Because the percentage ownership is fixed, the post-round valuation remains stable:
Post-round Valuation =	Pre-money Valuation + Total New Investment
Price Per Share =	Pre-money Valuation / (Pre-money Fully-Diluted Share Count + Option Pool Increase + Converted Shares)

Pre-money Post-financing dilution in the round modeling tool
Named because the effective pre-money valuation is fixed or pre-calculated, and all other values are derived from it. Convertibles following this method convert in post-money, which means they effectively convert after the round is completed. This results in dilution for both original shareholders and new investors due to the influence of convertibles.
As the pre-money valuation remains constant, the added value from the convertibles contributes to the post-money valuation:
Post-round Valuation =	Pre-money Valuation + Total New Investment + Converted Value
Price Per Share =	Pre-money Valuation / (Pre-money Fully-Diluted Share Count + Option Pool Increase)

Dollars-Invested *Not available in the round modeling tool
This method represents a middle ground between the previous two in terms of dilution. Under this method, new investors experience dilution from both the principal and accrued interest on the convertibles. In contrast, existing shareholders only face dilution from the discounted portion of converted shares. For existing shareholders, the total dilution is less compared to the percentage-ownership method.
Neither pre-money nor post-money valuation remains fixed under this method. Effective pre-money valuation is adjusted by subtracting the discounted convertible value:
Post-round Valuation =	Pre-money Valuation + Total New Investment + Convertible Principal + Interest
Price Per Share =	Pre-money Valuation / (Pre-money Fully-Diluted Share Count + Option Pool Increase + Converted Shares - Shares from Convertible Principal)

Method	Calculation	Post-money valuation	Impact on existing shareholders	Impact on convertible holders	Impact on new investors
Percentage-ownership	Set the investor ownership percentage to be fixed. New investors don’t see dilution from convertibles.	Fixed as expected Post-money valuation = Pre-money valuation + total new investment	Worst	Best	Best
Pre-money	Set the effective pre-money valuation to be fixed. New investors see dilution from convertibles.	Larger than expected Post-money valuation = Pre-money valuation + total new investment + converted value	Best	Worst	Worst
Dollars-invested	New investors see dilution from the principal (+ interest) of convertibles. Existing stakeholders only see dilution from discounted convertible value.	Slightly larger than expected Post-money valuation = Pre-money valuation + total new investment + convertible principal + interest	Medium	Medium	Medium

How to model a priced round