An equity deal is a transaction in which a company sells a percentage of its ownership to an investor in exchange for cash. The money never has to be repaid directly. The investor only makes a return if the company grows and the shares become worth more than what was paid for them, at which point the investor can sell. That shared-risk structure is why equity financing dominates startup fundraising, and it is why the fine print in these deals carries so much weight for founders, employees, and investors alike.
A company valued at $40 million that accepts a $10 million investment has sold 20% of itself. The founder keeps control of a larger pie that is now a smaller slice. Whether that trade works out depends almost entirely on terms the parties negotiate before any money moves.
What You’re Actually Selling
Every priced equity deal starts with a valuation negotiation, and two numbers do the work. The pre-money valuation is what the company is worth before the new cash arrives. The post-money valuation is what it is worth immediately after. The math is addition. A $40 million pre-money valuation plus a $10 million investment produces a $50 million post-money valuation. The investor’s ownership equals their check divided by the post-money number, so $10 million divided by $50 million gives them 20%.
The founder who owned 100% of the pre-money company now owns 80%. That reduction is dilution, and it happens to every existing shareholder every time the company raises. Dilution is not inherently bad. Owning 80% of a $50 million company is worth more than owning 100% of a $40 million one. But it compounds. A founder who raises a Seed, Series A, and Series B can easily end up with 30% or less of what they started. The right question at each round is not how much dilution, but whether the capital will create enough new value to more than offset the ownership given up.
When a company raises at a lower valuation than its previous round, that is a down round. Existing shareholders get diluted more severely because each dollar now buys a larger percentage. Employee stock options can go underwater, meaning the exercise price exceeds the current share value. Down rounds also trigger anti-dilution protections for earlier investors, pushing even more dilution onto founders and the employee option pool.
The Three Common Structures
Not every equity deal involves buying shares at a fixed price on day one. Early-stage deals often use instruments that defer the valuation question until a larger, priced round later.
A SAFE, or Simple Agreement for Future Equity, is the simplest form. Created by Y Combinator, it is not a loan: no interest rate, no maturity date, no repayment obligation. The investor sends cash, and the SAFE converts into equity when a triggering event happens, usually a priced funding round or an acquisition.1Y Combinator. YC Safe Financing Documents Conversion typically happens at a discount to the new round’s price or at a capped valuation, whichever gives the SAFE holder more shares.
A convertible note works similarly but is structured as actual debt. It carries interest and has a maturity date. If the company has not raised a priced round by that deadline, the note comes due. Like a SAFE, it converts into equity at a discount or valuation cap when a qualifying financing happens, and the accrued interest also converts, giving the note holder slightly more equity than a SAFE holder who put in the same amount. Convertible notes give the investor a legal fallback a SAFE does not: if things fall apart, the investor is technically a creditor.
A priced round is the traditional equity deal. The company and investors agree on a specific valuation, and the investor buys shares at a fixed price per share. Series A rounds and everything after are almost always priced rounds, and the legal documentation is significantly more involved than a SAFE or note.
Who Invests at Each Stage
The earliest money comes from angel investors, wealthy individuals investing their own funds, typically between $25,000 and $500,000 per deal. Angels take enormous risk because the company usually has little more than a prototype and a founding team. In exchange, they get equity at the lowest valuation the company will ever carry.
Once a company shows real traction, institutional venture capital enters. VC firms pool money from pension funds, endowments, and other large institutions, then deploy it through named funding rounds. A Seed round builds the product. A Series A, often $5 million to $20 million, funds the shift from “this works” to “this scales.” Series B and C rounds push into new markets, hire aggressively, and can involve checks of $50 million or more. Each round adds new investors, new terms, and new complexity to the capitalization table.
Growth equity sits in a later, calmer tier. These investors target companies that are already profitable or close to it but need large infusions to acquire competitors, expand internationally, or prepare for a public offering. The risk profile is lower, due diligence is heavier, and the expected return is more modest than early-stage venture capital.
The Terms That Decide Who Gets Paid
Ownership percentage is only half the story. The terms attached to the investor’s shares determine who actually gets paid, and how much, when the company is sold or goes public. Founders who focus only on valuation and ignore these provisions often find at exit that the math does not work in their favor.
Liquidation Preferences
A liquidation preference guarantees that investors get paid before common shareholders (founders and employees) receive anything from a sale or liquidation. The standard version is a 1x non-participating preference: the investor chooses between getting their original investment back or converting to common stock and taking their proportional share of the total proceeds, whichever pays more.2LTSE. What is Liquidation Preference In a strong exit they will convert; in a weak one they will take the guaranteed return.
A participating preference is more aggressive. The investor gets their original investment back first, then also takes a pro-rata share of what remains alongside the common shareholders.2LTSE. What is Liquidation Preference On a $50 million sale where the investor put in $10 million for 20%, they would collect $10 million off the top, then 20% of the remaining $40 million ($8 million), for a total of $18 million. Under a non-participating preference they would receive $10 million. The $8 million difference comes directly out of what founders and employees take home.
The multiple matters too. A 1x preference returns the original investment; a 2x preference returns double. Multiples above 1x appear in riskier deals or when investors have more leverage. Founders should always calculate the total liquidation overhang across all rounds to understand what minimum exit price is needed before common shareholders see a dollar.
Anti-Dilution Protection
Anti-dilution clauses protect investors if the company later raises at a lower valuation. The two main types behave very differently. A weighted average adjustment lowers the investor’s conversion price using a formula that accounts for how many new shares were issued and at what price. It is more common and more founder-friendly because the adjustment is proportional to the severity of the down round.
A full ratchet adjustment is harsher. It resets the investor’s conversion price to the new, lower price, as if they had invested at the down-round valuation all along. This can dramatically increase the investor’s share count and crush founder ownership. Full ratchet is rare in competitive deals but surfaces when investors hold significant leverage.
Founder Vesting
Investors almost always require founders to vest their own shares over time, even shares the founders already hold. The standard schedule runs four years with a one-year cliff: no shares vest during the first year, 25% vest at the one-year mark, and the remainder vests in monthly or quarterly increments over the following three years. If a founder leaves before fully vesting, the company can repurchase the unvested shares at cost.
Vesting protects all parties. If one co-founder quits six months after a major investment, it prevents them from walking away with their full stake while contributing nothing further. Founders sometimes negotiate acceleration clauses that speed up vesting if the company is acquired or if they are terminated without cause.
Pro-Rata, Drag-Along, and Tag-Along Rights
Pro-rata rights let an investor invest enough in a future round to maintain their ownership percentage. If they own 10% and the company raises a Series B, pro-rata rights allow them to buy enough Series B shares to stay at 10%. Companies typically grant these selectively to their largest or most helpful investors.
Drag-along rights let a majority of shareholders force the minority to participate in a sale on the same terms. If 80% of shareholders approve an acquisition, drag-along provisions prevent the remaining 20% from blocking it. Tag-along rights work the other way: if a majority shareholder sells, minority holders can insist on selling on the same terms, protecting them from being stranded with new, unknown controlling shareholders.
How the Deal Comes Together
An equity deal follows a fairly predictable sequence, though the timeline ranges from weeks for a simple angel round to several months for a large Series B.
Before talking to investors, the company assembles a data room: a secure digital repository with financial statements, corporate formation documents, intellectual property records, material contracts, cap table details, and projections. The quality of this data room directly affects how fast due diligence moves. Sloppy or incomplete records are the single most common cause of delays and blown deals.
When an investor decides to move forward, both sides negotiate a term sheet, a short document (often under ten pages) outlining the core economics and governance rights of the proposed deal. It covers valuation, investment amount, liquidation preferences, board composition, protective provisions, and anti-dilution terms. The term sheet itself is not a binding commitment to invest, but the exclusivity clause (barring the company from shopping to other investors for 30 to 45 days) and the confidentiality obligations usually are. Once signed, renegotiating individual provisions becomes extremely difficult because the investor treats it as the agreed framework for the definitive documents.
After the term sheet is signed, the investor’s team digs into the data room. Financial due diligence scrutinizes historical revenue, quality of earnings, and whether projections are grounded in reality. Legal due diligence examines corporate formation, employment agreements, material contracts, customer agreements, and any pending or threatened litigation. Technical due diligence may evaluate the product architecture, code quality, and intellectual property defensibility. Undisclosed liabilities, messy cap tables, or contracts with unfavorable change-of-control provisions can kill a deal or force a valuation renegotiation.
The deal closes with the execution of definitive legal agreements and the transfer of funds. In venture capital transactions, the standard closing package reflected in the widely used NVCA model documents is not a single contract but several: a stock purchase agreement governing the share sale and the company’s representations and warranties; an investors’ rights agreement covering financial reporting, future registration rights, and pro-rata rights; a voting agreement specifying board composition and matters requiring investor approval; and a right of first refusal and co-sale agreement giving the company and investors the first chance to buy founder shares, with tag-along rights if a founder does sell.3National Venture Capital Association. NVCA Model Legal Documents Once everything is signed, the investor wires funds, the company issues new shares, and the cap table is updated.
The Federal Rules Behind Private Offerings
Selling equity in a company is selling a security, and federal law requires every securities offering to be registered with the SEC unless a specific exemption applies. Nearly all startup equity deals rely on Regulation D for that exemption.
Under Rule 506(b), a company can raise an unlimited amount but cannot publicly advertise or generally solicit investors. The offering can include up to 35 non-accredited investors, though each must be financially sophisticated enough to evaluate the investment’s risks.4eCFR. 17 CFR 230.506 – Exemption for Limited Offers and Sales Without Regard to Dollar Amount of Offering In practice most 506(b) deals stick to accredited investors only, because including non-accredited investors triggers additional disclosure requirements.
Rule 506(c) allows general solicitation and public advertising, but every purchaser must be an accredited investor, and the company must take reasonable steps to verify that status rather than accept a checkbox on a form.4eCFR. 17 CFR 230.506 – Exemption for Limited Offers and Sales Without Regard to Dollar Amount of Offering Verification methods include reviewing tax returns for income-based qualification or bank statements for net-worth-based qualification.
An individual qualifies as accredited by meeting any one of these tests: individual or joint net worth with a spouse or spousal equivalent exceeding $1 million, excluding the primary residence; individual income above $200,000 in each of the two most recent years (or $300,000 jointly) with a reasonable expectation of reaching that level in the current year; or holding certain SEC-recognized professional credentials, including Series 7, Series 65, and Series 82 licenses.5eCFR. 17 CFR 230.501 – Definitions and Terms Used in Regulation D
After the first sale of securities under Regulation D, the company must file a Form D notice with the SEC within 15 days.6U.S. Securities and Exchange Commission. What is Form D? An annual amendment is required if the offering remains open beyond 12 months. Most states also require their own notice filings under blue sky laws, with fees and deadlines that vary by jurisdiction. Missing these filings does not invalidate the deal, but it can trigger fines and complicate future fundraising.
Tax Deadlines That Catch People Off Guard
Equity deals create tax events, and the deadlines involved are unforgiving.
The 83(b) Election
When founders receive restricted stock that vests over time, the default tax treatment taxes the stock as ordinary income each time a batch vests, based on the stock’s value at that moment. If the company’s value has grown between grant and vesting, the tax bill can be enormous.
A Section 83(b) election flips that default. By filing the election, the founder pays income tax on the stock’s value at the time of the grant (often when it is worth very little), and any future appreciation is taxed at the lower long-term capital gains rate when the shares are eventually sold. The catch: the election must be filed with the IRS within 30 days of the stock grant, and that deadline cannot be extended.7Office of the Law Revision Counsel. 26 USC 83 – Property Transferred in Connection With Performance of Services Missing it is irreversible. If the stock is forfeited later because the founder leaves before vesting, no deduction is allowed for the tax already paid.
409A Valuations
When a private company grants stock options to employees, the exercise price must be set at or above the stock’s current fair market value. If the IRS determines options were priced below fair market value, employees face a 20% penalty tax on top of ordinary income tax, plus interest charges.8Office of the Law Revision Counsel. 26 USC 409A – Inclusion in Gross Income of Deferred Compensation Under Nonqualified Deferred Compensation Plans
To establish a defensible fair market value, companies hire independent appraisers for what is known as a 409A valuation. This appraisal must be updated at least annually and refreshed after any material event, including a new funding round, a major contract, or a significant change in revenue trajectory. The cost for a startup typically runs from a few thousand dollars to around $10,000. Every equity deal that sets a new valuation effectively forces a 409A update for any options granted afterward.
Qualified Small Business Stock
Section 1202 of the Internal Revenue Code offers a powerful tax benefit for investors in small companies. If the stock qualifies, a portion or all of the capital gains from selling it can be excluded from federal income tax entirely. For stock acquired after July 4, 2025, the exclusion is tiered by holding period: 50% for shares held at least three years, 75% for at least four years, and 100% for five years or more.9Office of the Law Revision Counsel. 26 USC 1202 – Partial Exclusion for Gain From Certain Small Business Stock The per-issuer cap on excluded gain is the greater of $15 million or 10 times the taxpayer’s basis in the stock.
Eligibility is narrow. The company must be a domestic C corporation with aggregate gross assets of $75 million or less at and before the time of issuance. At least 80% of the company’s assets must be used in an active qualified trade or business for substantially all of the holding period. Several industries are excluded outright, including financial services, law, health services, consulting, engineering, accounting, and any business whose principal asset is the reputation or skill of its employees. Founders should confirm QSBS eligibility before choosing their corporate structure, because S corporations and LLCs do not qualify.