Most of us know that when you raise funds at a startup, your company's ownership percentage decreases. As a founder, your goal is to enhance the startup's value, so the smaller percentage of a much larger value of your business will increase your absolute personal value than it was before funding.
- Startup founders dilute their percentage of holding and ownership in the company by issuing new shares in exchange for new capital being brought in by investors.
- As startups grow, founders may give out stock options to employees, advisors, and board directors to compensate for their work. New shares are added when the stock option holders exercise the option.
- Dilution also reduces a company's earnings per share (EPS), which can negatively impact share prices in the market.
- Startup founders need to know how to avoid dilution and loss of shares by clarifying the money they need at each stage and not raising more money than what is required.
- There are startup dilution calculators available, using which you can enter some minimum input data to compute the results of equity dilution.
The following section explains what dilution is, why it is required, and how it can significantly change your ownership position.
What is Startup Dilution?
In the early stage of a startup (say, the pre-seed stage), 100% of the equity is owned by the founders, sometimes with relatives and friends. Hence the total control over the company lies with the founders' circle. This scenario changes when the startup needs more funds from outside investors to steer the company to the next level. When the new funding occurs, the existing equity holders concede a certain shareholding percentage to the new investors. The decrease in the percentage of holding and ownership of existing shareholders due to issuing new shares to the incoming investors is called dilution.
Any subsequent equity dilution can significantly impact the ownership stake of founders and other existing investors. To better understand the concept of equity dilution, let us imagine that Investor A owns all 900 shares—100% shareholding—of A's startup company. Now, assume that the company raises new equity funding by issuing 100 new shares to Investor B. After this new investment from Investor B, Investor A's holding and ownership percentage go down from 100% to 90% (900 shares/1000 shares). Investor A's stake in the company has been diluted because 10% holding has been conceded to Investor B.
Here, you must note that just because the percentage of the shareholding of Investor A has gone down after the funding round, the value of the Investor A's holding has not necessarily decreased. Whether value decreases or increases after a funding round depends on the company's overall valuation; post-money valuation, the company's valuation after the funding round, is determined during each funding round based on many factors and criteria. In either case, the percentage of ownership of existing stockholders goes down after each dilution.
Why Founders Opt for Dilution of Their Stakes?
Undoubtedly, founders would like to retain control over their startup company forever, but it won't be practically possible if they want the startup to scale and grow. Let us go over the top reasons why founders allow equity dilution:
- Cash flow challenges: A cash-strapped startup may not have succeeded in sourcing funds through other means and has no option other than dilution to raise funds. This happens mostly in the early stages, like pre-seed and seed.
- Attract talents: Getting promising talents in the team is critical for the growth of startups, but it is a challenge in the early stages. The best way to attract top-caliber employees is to offer stock options, which is commonly known as ESOP (employee stock option plan). Most investors insist on setting up ESOP before their investment.
- Utilize advisory services: In the early stages, the founders focus on business, products, and customers. The other functions, often labeled as non-business or back-office functions, such as finance, human resources, including payroll, legal and regulatory, usually get sidelined and neglected. This can be detrimental to the business but happens mainly because of the founders' lack of expertise or bandwidth. The importance of advisors comes here. Advisors are normally compensated through cash, shares, stock options, or a combination of all of some of them.
- Leverage expertise: Founders sometimes take the view that the experience and knowledge that the new investors bring to the table will add more value to the company than the stake the founders lose out. This is relevant in seed and series-a onwards.
- Drive growth: Most founders want to maximize the value of their startup and, in turn, the worth of their equity stake. Startups need capital to invest in product development and marketing strategies to drive the growth of the business in their seed-a and series-b stages.
Types and Sources of Equity Dilution
We will now examine some of the critical types or sources of dilution of startup equity:
- Issuance of new shares to investors who bring investments at various stages to improve growth, profitability, and value of the business or to buy/acquire another company
- Exercising stock options by employees, advisors, or board members adds new shares whereby the outstanding stocks, aka 'float,' increase
- Converting the convertible securities into stock as per the terms of such securities
- Dilution can also take place in an initial public offering (IPO), though it depends on whether the offered shares are new shares or existing shares that were privately owned by company employees or investors
How Does Startup Equity Dilution Work in Various Funding Rounds?
A startup company passes through various stages of its lifecycle, and its funding needs vary in each stage, such as pre-seed, seed, series-a, series-b, and beyond. In each stage of the financing process, the valuation of the company and the stake of investors change. The value of a successful startup generally increases as it grows or matures, so the investors must bring in more funds to receive the same percentage of ownership.
The impact and magnitude of dilution depend significantly on the decisions of each startup's founders and investors, as well as the startup's performance. Such decisions include special provisions within investor agreements, such as anti-dilution provisions, which prevent an investor's stake from being diluted in future rounds, and pro-rata rights that allow investors to participate in subsequent rounds, to maintain their ownership percentages intact.
We will take a look at how the dilution works and how it impacts the existing shareholders:
When you start your business, you own 100% of the company, the whole cake. The fund coming from your savings and contributions by relatives and friends won't be enough for you to hire new talents to, say, develop an MVP (minimum viable product) or generate traction and advisors to show you the way forward. Both are critical for you to take your startup forward.
Imagine that you will give 10% of the holding and ownership of your company to these early, risk-taking talents and advisors. Mostly, you agree to pay them through stock options because you don't have funds to pay them in cash. The result: you now own 90% of the company, and your new team and advisors own 10%.You have diluted 10% of your ownership.
Imagine that your new team helped you develop an MVP and generate traction, and advisors helped you with insights. You have now found and finalized a nice seed-stage fund. You are giving 10% of your startup to seed investors. The result:
- You own an 81% (90% times 90%) stake in the company.
- Your team has 9% (90% times their 10%).
- The seed investors have their 10%, all totaling 100%.
The seed funding helped you scale up, and now you are ready for the Series-A round. Imagine that your seed investors introduce you to Blue Chip Ventures who do series-a and beyond. Blue Chip negotiates for 20% of the ownership and demands a 20% ESOP post-fund. Finally, both agree to an ESOP of 10%.
You realize that the role of the advisors is critical at this juncture. You had advisors from the pre-seed stage at a very lean level and were paid in cash. Now, the scope has increased to include mandates, like -
- advice on how to set up these functions,
- designing the processes and workflows,
- whether to outsource them and to whom,
- how to calculate equity dilution and understand its impact at different stages,
- what do the estimated numbers mean to the founders in the short term and long term,
- when to propose exit/IPO, etc.
Blue Chip agrees to offer 1% to the advisor so that ESOP will be 9% and advisors 1%. The value of both options is taken out of the pre-money valuation, i.e., the dilution from the option pool is taken before the Blue Chip investment. Before we look at the series-a math, let's look at what needs to happen with the first ESOP and advisor option.
Look at this. It is not 10% but 12.5% you are diluted pre-money while setting up post raise 10% ESOP plus Advisor option. This is because when the post-money 10% option pool is set up, everyone is diluted 12.5% before investment.
So let us check how the ESOP plus Advisor math work:
- The post-money dilution of series-a is 20%, and the ESOP is 10%. So you divide the 10% by 1 minus the series-a to arrive at 12.5% (pre-money ESOP plus Advisor).
- The result: Pre-money but post the ESOP, the founders now own 70.9% (81% times 87.5%, which is one minus the 12.5%), the team and advisors together own 7.9%, and the seed 8.8%.
Now, look at Series-A math:
- When the Series-A investment closes, everyone is getting diluted 20% except Blue Chip which has just joined your cap table.
- The result: the founders now own 56.7% (70.9% times 80% which is one minus 20%), the team plus advisor own 6.3%, the seed investors own 7%, Blue Chip owns 20%, and there is a post raise ESOP of 10%. All of these add up to 100% again.
Your startup reaches the Series-B stage when it has attained good growth and investor confidence in your company and your leadership. Assume that Blue Chip introduces you to Diamond Investors who agree to do the series-b round for 25% and demand to top up the ESOP at 10% post-money. The fundamentals of math remain the same, but it gets a bit complex.
Let's look at the Series-B dilution math as we have done before:
- You start with diluting everyone by 25%, the Series-B investor stake.
- You calculate the 10% ESOP you need post raise by dividing by 1 less than the 25%.
- Then you deduct the initial ESOP of 10% you already have.
- The result: You own 41%. Your team that started with 10% now owns 4.6%. Your seed investors are down to 5.1%, and the series-a investor who started with 20% is down to 14.5%. The total of both ESOP plus Advisors is at 10%.
- The Diamond Investors have not been diluted, so they own 25% as of series-b post raise, but they will lose share in the next round (if any).
- Again, all totals 100%.
Startup Equity Dilution Calculator
When you move to more down rounds coupled with options, the calculation becomes a bit tedious. It is time to use a Dilution Calculator. You will simply input the currency, the amount you are raising, the post-money equity percentage you are offering to investors, and the number of shares issued before the fundraising round in the startup dilution calculator to compute the diluted equity values. Many dilution calculators are available, like the calculator provided by SmartAsset, to help you calculate dilution under different scenarios.
As you have seen, your startup goes through various stages of its life cycle. You come across issues relating to equity dilution in each stage that can significantly affect the future of your company, your stake, and your wealth. It would be best if you gained a thorough understanding of the nuances of this topic to help make wiser fundraising decisions. You, without doubt, will analyze the size of the round and the valuation, but it is pertinent that you analyze the terms sheet of the deal diligently. If you care to avoid mistakes in the processes at different stages, you will grow your startup while maintaining better control.
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