Prerequisites

This guide assumes an advanced understanding of equity, liabilities, and startup finance terminology. You’ll need access to detailed financial models.

Overview

75 min
Setup Time
Expert
Difficulty
Quarterly
Maintenance

What You’ll Learn

  • Accounting for convertible notes and SAFEs
  • Journal entries for stock option grants
  • Impact of dilution on shareholder equity
  • Preparing for Series A/B fundraises
  • Valuing equity and option grants

1. Core Concepts & Definitions

Before diving into the numbers, let’s define key terms critical for dilution and cap table management:

Key Terms

  • Convertible Note (Debt/Equity)
  • SAFE Agreement (Equity)
  • Stock Options (Equity)
  • Warrants (Equity)
  • Shareholder Equity (Equity)

Key Concepts

  • Pre/Post-Money Valuation
  • Option Pool
  • Fully Diluted Shares
  • Waterfall Analysis

2. Understanding Dilution & Its Impact

Dilution is a natural part of startup growth, but understanding its mechanics is crucial.

Equity Investors vs. Option Holders

Different stakeholders experience dilution differently.

Equity Investors:
  • Direct ownership stake
  • Voting rights (typically)
  • Participate in liquidation events
Option Holders:
  • Right to buy shares at a set price
  • No direct ownership until exercised
  • Value depends on future valuation

3. Accounting for Convertible Instruments

Convertible notes and SAFEs are common early-stage fundraising tools. Here’s how to account for them.

Expert Tip: For valuation of stock options, particularly with complex vesting schedules, consider using the Black-Scholes model. This requires assumptions about volatility, dividend yield, risk-free rate, and expected term.

Here is a sample code block to show how a convertible instrument might be represented.

{
  "instrument_type": "Convertible Note",
  "issuer": "StartupCo",
  "investor": "Angel Investor",
  "principal_amount": 100000,
  "interest_rate": "5%",
  "conversion_event": "Qualified Financing"
}

4. Step-by-Step: Journal Entries

Here is the high-level workflow for critical equity-related journal entries.

  1. 1

    Record Issuance of Convertible Note

    Debit: Cash, Credit: Convertible Note Payable

  2. 2

    Accrue Interest (if applicable)

    Debit: Interest Expense, Credit: Interest Payable

  3. 3

    Convert Note/SAFE to Equity

    Debit: Convertible Note Payable / SAFE Liability, Credit: Common Stock, Credit: Additional Paid-in Capital (APIC)

  4. 4

    Grant Stock Options

    Debit: Compensation Expense, Credit: APIC - Stock Options (over vesting period, if expensed)

Common Error: Misclassifying SAFEs

SAFE (Simple Agreement for Future Equity) agreements are typically accounted for as equity instruments, not debt, as they have no maturity date or interest. Ensure proper classification on the Balance Sheet.

5. Cap Table Reconciliation & Dilution Impact

Cap Table Reconciliation Checklist

  • Verify new shares issued match financing documents
  • Recalculate ownership percentages post-round
  • Update fully diluted share count for all instruments
  • Assess dilution impact on existing shareholders

Need Help?

Expert Cap Table Review

Navigating complex startup equity? Our specialists can help ensure your cap table is accurate and compliant for your next fundraise.

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