Startup equity dilution is an important concept to understand as you navigate the fundraising process.
Founders and operators typically pour their hearts and souls into building their businesses. This mental and emotional investment is repaid in the form of equity, i.e. an ownership stake in the company.
The startup journey often involves raising capital from outside investors, however. And with each funding round comes a potential decrease in your ownership percentage. This is known as equity dilution.
As the CFO of York IE, I manage our corporate strategy and finance services for fast-growing technology companies. Startup dilution is a common topic for many of our clients as they scale, fundraise and reward loyal employees. In this blog post, I’ll tap into some of the best practices I’ve learned from helping founders and operators manage their equity dilution:
What Is Equity Dilution?
Equity dilution refers to the reduction in ownership percentage of existing shareholders when additional shares are issued. It typically occurs when a startup raises capital by selling new shares to investors, such as during Seed or Series A rounds, or by allocating shares to any equity option pool for employee compensation. Dilution may also occur, but be delayed, through a convertible note or Simple Agreement for Future Equity (SAFE) when the positions are converted to equity well after the fundraise.
Startup equity dilution isn’t inherently good or bad. On one hand, every time you raise money from a venture capital firm or other investor, you’re effectively selling a piece of your company to an outside party. Founders and operators should be strategic about how much they’re raising and how much equity they’re selling off.
There is, however, another side of the equation. An injection of capital might allow you to scale your business and increase your valuation. In the long term, owning a smaller percentage of a more valuable company might be more beneficial than claiming a larger share of equity in a less valuable organization. Plus, many investors serve as active advisors who can help grow your company strategically.
How Does Dilution Work?
Dilution is measured relative to the number of total shares of equity in a company. If you know the total number of shares available in your company (which might not always be the case), you can express dilution with this formula:
new ownership percentage = (your number of pre-money shares) / (total shares outstanding after round)
Pre-money shares are what you own before the funding round. Total shares outstanding are the total number of shares in the company after the new investors are included.
For example: Let’s say you own 10 out of 100 shares in your company, equal to 10%. You conduct your Seed round, in which you issue 25 new shares to your investors.
You now own 10 of the 125 shares of the company, reducing your new ownership percentage to 8%.
I want to be clear that this is a very simplified version of a startup equity dilution calculation. The math is a little bit more complicated when you start dealing with SAFEs and convertible notes (and pre- and post-money valuations).
What Is an Equity Dilution Event?
An equity dilution event is any event that triggers a reduction in the ownership percentage of existing shareholders. This can refer to more traditional fundraising rounds you’re familiar with, but also stock option grants to employees, conversions of SAFEs and convertible notes, or even mergers and acquisitions where shares are exchanged.
Causes of Startup Equity Dilution
Startup equity dilution can be caused by:
- priced fundraising rounds;
- the creation or expansion of an employee/advisor stock option pool;
- a merger or acquisition; and
- convertible notes and SAFEs.
Priced Fundraising Rounds
Each time you raise capital through the issuance of new shares (aka a priced round), your ownership percentage decreases. Hopefully, your company will achieve a higher valuation with each successive round. Although you’re likely to experience startup dilution from each round, the real-money value of your equity will likely increase if your valuation does.
Employee Stock Options
Many startups like to reward their early and key employees with shares in the company. This can be a great incentive that allows employees to reap rewards when the company succeeds. It can also be a great negotiating tool to offset cash compensation with equity when capital resources are slim.
Typically, the board of directors will create an option pool; they’ll take a certain number of shares and set them aside. There’s a distinction between authorized shares allocated to the option pool (i.e., ones the board has set aside) and issued shares (ones that have been awarded to employees and advisors). Only issued and vested shares have an immediate impact on equity dilution.
Mergers and Acquisitions
Let’s say your company is acquired with stock as part of a deal. In this case, the conversion ratio between your shares and the acquiring company’s shares will determine the final ownership stake for founders and other shareholders. Negotiating a favorable conversion ratio becomes crucial to minimizing dilution in this scenario. Remember, even in an acquisition, a smaller ownership stake in a much larger, successful company can be a very positive outcome.
Convertible Notes and SAFEs
Debt instruments such as convertible notes and SAFEs will convert into equity at a discount during a future fundraising event. Because of this, the dilutive impact of these instruments is not immediately understood at the time they’re agreed upon.
How to Prevent Share Dilution for a Founder
Here are a few ways to prevent share dilution:
- Conduct sound financial and capital runway planning.
- Raise only what you need.
- Negotiate your valuation.
- Manage your option pool wisely.
- Explore alternative financing options.
- Play the long game.
1. Conduct sound financial and capital runway planning
Growth at all costs is a thing of the past. Keep a close eye on the company’s capital structure and how future funding rounds may affect it. Understanding potential dilution scenarios can help founders make informed decisions.
2. Raise only what you need
Don’t fall into the trap of raising more capital than necessary. Every dollar raised comes at the cost of some equity. Sure, it might feel good to announce new funding every six months, but you’ll likely do some serious damage to your ownership percentage. Carefully plan your runway and focus on achieving key milestones before seeking additional funding.
3. Negotiate your valuation
The higher the valuation you secure during fundraising, the fewer shares you need to issue to raise the same amount of capital. That’s because a higher price per share buys the new investor fewer shares with their fixed amount of capital. This translates to less dilution for you and your co-founders.
Before entering negotiations, research valuation benchmarks for similar companies in your industry and at your stage. Clearly articulate your company’s potential for growth and profitability to justify a higher valuation. Consider bringing in a fundraising advisor such as York IE to help you understand your valuation inputs, navigate the negotiation process and ensure you’re getting the best possible terms.
4. Manage your option pool wisely
Stock options are a crucial tool for attracting and retaining talent, but a bloated option pool can significantly dilute your ownership.
Once again, consider benchmarking against industry standards and tailor the pool size to your specific needs and stage. Implement vesting schedules that require employees to stay with the company for a certain period to fully acquire their stock options. This incentivizes long-term commitment.
Prioritize granting options to key hires and employees with high-growth potential. This part becomes especially crucial in the early stages of your company. The first few hires you grant equity to will set the standard for future equity grants. Think long-term and don’t set the bar too high.
5. Explore alternative financing options
Debt financing or revenue-based financing can provide growth capital without immediate equity dilution. Roughly 34% of small businesses apply for loans in a given year. Consider options such as venture debt alongside traditional equity fundraising for a more balanced approach. While the interest costs of startup loans can be high, alternative financing might still fit into your company’s overall capital strategy.
6. Play the long game
While dilution might seem like a loss in the short term, remember: It’s all about building long-term value. If your company experiences significant growth and achieves a successful exit (acquisition or IPO), even a smaller ownership stake can translate into a substantial financial reward.
Typical Dilution for a Seed Round
Founders should expect between 15% and 30% dilution in a Seed round. Put another way, you’ll likely have to give your investors between 15% and 30% of your company shares in exchange for the capital you need.
Typical Series A Dilution
Founders conducting their Series A financing should expect between 15% and 25% startup dilution. Series A companies are typically a little further along than their Seed counterparts, meaning dilution tends to skew slightly lower in this round. This is because the valuations tend to be a bit higher.
Startup Equity Dilution Example
Let’s take everything we’ve learned about startup equity dilution and put it into a hypothetical story:
Lauren Williams has had early success with her startup. She has strong product market fit and great traction with a couple of well-known brands. Lauren has identified key areas for investment that will allow her to scale her business but needs additional capital to reach her milestones sooner.
After considering non-dilutive options, like a bank loan or revenue-based financing, Lauren decides that a traditional equity raise is the best approach for her company.
Lauren previously raised $600,000 from a few close investors. In that Seed round, the company was valued at $2.7 million pre-money. Lauren retained 82% ownership of the company after the round.
Lauren weighs several factors when considering how much to raise in her upcoming Series A, including her company’s valuation and its capital requirements. With help from her advisors, Lauren determines that a $1.5 million raise is best suited for her company, and her company could reasonably be valued at $9 million pre-money.
When the round is completed at her terms, it has a 14% dilutive effect on the ownership position for folks on the cap table. This is calculated by the simple math on the new investment as a percentage of the new valuation:
$1.5M invested / $10.5M post-money valuation = 14% of the company
After the Seed round, Lauren owned 82% of her company. The Series A raise of $1.5 million reduces her ownership allocation to 70%. Since the valuation also increased, she secures an unrealized gain of $4.6 million. Although 14% dilution is significant, Lauren feels this outcome will be an overall win, because her diluted ownership percentage will be worth a far greater value in real dollars when the company reaches a successful exit.
Ownership in your company is a big deal. If you’re a founder or operator, you’ll likely sacrifice much of your physical, mental and emotional energy into growing your company. Strategically managing your startup dilution will help ensure that your company’s success will correlate to personal financial gains to reward your hard work.
