Equity Dilution in Startups
Fundraising decisions are one of the most important aspects for early-stage founders when seeking growth objectives. How fundraising can affect their company and shareholders isn’t always understood.
The basic concept is that as a startup undergoes a fundraising round, the founder’s ownership percentage is reduced.
The equity dilution has long-term implications that should be taken into consideration early on.
Equity dilution is the decrease in equity ownership that occurs for existing shareholders when a startup issues new shares.
Founders generally start out as 100% owners of their company. However, every time that capital is raised, the equity owned by the founder is reduced.
Founders vs Investors
To see how this could work, let’s use the following example:
A startup with two founders each has a 50% stake in the company, meaning they own 100%. They decide to raise capital with a funding round to grow their business further. They decide to raise $2 million at $20 per share with a venture capital firm.
Each founder has a 33% stake in the company, 66% collectively.
The influx of cash allows a startup to grow further by providing funds to invest in needs such as hiring the right staff, build out the product/service, and marketing.
This is a common approach for a startup founder to undergo a series of funding rounds to build the infrastructure necessary for becoming a viable company in the future.
Giving up shares in the company in return for investment is generally an unavoidable situation, nor is it something to try to avoid as long as it’s done properly.
Just a note for early-stage founders. Not every small business is a startup, and fundraising isn’t always the best strategy for a company. If you are not planning to grow quickly, maybe raising capital from investors isn’t a good fit for your business development. If you are raising funds from investors though, understanding the implications with dilution is fundamental.
Just as a startup founder may experience this equity dilution, an investor is susceptible to this as well. In the example shown above, 34% of shares belong to the investors. If the company decides to have another series of fundraising, an investor who originally invested in that first round could have their ownership diluted further.
Here’s another general example from the perspective of an investor.
Let’s say the company issued 10 shares of ownership that equate to 10% ownership that a single investor purchased. An investor in this case would have 10% ownership of the company. Later the company issues 10 new shares which another investor decides to buy.
There is a total of 20 shares outstanding with a total value of 10% of the company. The new investor owns 5% of the company, as does the original investor. The original investor’s original 10% stake has been diluted as a result of these new shares. Investors especially those who make investments in these early stages generally don’t have control over additional rounds of funding occurs.
Why Equity Dilution is Important
Getting an influx of money provides a startup with room to grow. The tradeoff is that as a founder, you are giving up your control for the future. Ian Foley who worked on several startups including Credit Sesame once remarked,
“Only take as much capital as you think you really need.”
This is an important lesson for startup founders to consider when determining how much funds to raise.
Determining the amount of capital to raise is the most challenging aspect, especially during the early stage startup beginnings. Founders that raise too much are running into the risk of unduly giving away a large amount of their company. On the flip side, if you don’t raise enough, you may have to go back to your investors again if you miss out on reaching certain milestones.
Let’s look at this from the perspective of your investors too. Some founders may think that because of the basis of dilution, their investors may not be on board with your fundraising goals. At the end of the day, your investors want your business to succeed.
That’s why they are investing in you in the first place. They believe in you as the founder of the company to the next level because they want to see a return on their investment.
As a founder, you should have clearly thought out how the effects of dilution will impact your investors. Be prepared to discuss why this dilution is necessary for the future of the business.
Forms of Equity Dilution
There are a number of different ways that a founder and its investors may experience the effect of equity dilution that should be understood. Too often, when topics around dilution arise, the thoughts that being considered focus on your ownership percentage.
The dilution that causes a reduction in your ownership percentage is a factor in your long game. However, this is not the same as how each dollar is distributed when there is a payout.
A new round, issuing shares, and other dilution causing event like this will lower your ownership stake when in terms of:
- Number of Shares
- Conversion Rate to Common Stock
- PIK Dividends
The other consideration when it comes to equity dilution that should be considered is how your payout is affected. There are terms that will cause the monetary value of your shares to be reduced. Terms that should trigger you to think of fewer dollars per share at a liquidity event are:
- Cash Dividends
- Participation Rights
- Liquidation Preference
Common Stock and Preferred Stock
To fully understand dilution, you must also understand the roles that common and preferred stock play. The key difference between a common and preferred stock is that shareholders who have preferred stock have special rights over common stock shareholders.
Some of the common rights that preferred stockholders often have are the ability to convert their shares to common stock or allowing them to keep their preferred rights when participating in common stocks. One of the reasons why a preferred shareholder would want to convert their shares to common stocks is because of the equity cap placed on preferred shares.
Number of Shares
The most common and obvious form of dilution occurs with the number of shares terms. To determine your ownership percentage, you take the total number of shares you have and divide it by the total shares that have been issued. This basically means the more shares you have, the greater portion of the company you own.
Pre-and post-money valuation calculations can help founders anticipate how much dilution will occur in the future. During the pre-revenue stage of a start-up, some of the most commonly used methods for determining startup valuations include the Berkus, Scorecard (also known as the Bill Payne valuation method), and Risk Factor summation methods.
What’s important to remember about your company’s share count is that there is actually a legal limit to how many shares can be issued. Amending your articles of incorporation is the only way to change how many shares your company can have. Setting up your company appropriately at the beginning can help you save this time and cost later on.
Another consideration to make is that it is common for investors to require that shares are allocated in an option pool for future employees. This form of stock-based compensation happens before an investor actually invests. So that means that any current shareholder would have their shares diluted to create this option pool. Meanwhile, these new investors would not see the dilution of their shares during that round.
Conversion Rate to Common Stock
This term applies when preferred stock is exchanged for common stock during a distribution event. How this term works is that it allows a shareholder to take their shares to common at a rate that’s multiped. For example, if they get 2 times, they would get twice as many shares.
Preferred stock shares have advantages over common stock, but there are reasons why an investor may decide to forgo these benefits for common stock. In these cases, the shareholder is waiving their preferred rights.
Let’s say that a shareholder has 10 shares of preferred stock that’s worth 10% of the company with a 1x liquidation preference. Each of these shares is worth $1. If during liquidy the shareholder invests another $10, receiving 1X of their shares, but not 10% of the company. As an alternative, the investor could negotiate a 1X liquidation preference and a 2X conversation rate to common stock. The shareholders would double their shares to 20 and have a little over 18% ownership of the company.
Giving shareholders the first opportunity during liquidity is called liquidation preference. Essentially what that means is shareholders who have a liquidation preference have priority in getting their money over others.
You will typically see a 1x liquidation preference given to investors so that they will at a minimum break even by getting their initial investment back prior to common shareholders receiving their distribution. When a liquidation preference of 2x, 3x, etc. is given, that multiples the rate of return by that number. I.e. 3x means they will get three times their initial investment.
As you could imagine, this could get out of control very quickly, with the possibility of some investors not receiving any liquidity at all. It is more common for investors to receive a 1x liquidation preference and 1x convertible rate to common. That way an investor is at least guaranteed they’ll get their investment back as long as the exit value is high enough. In cases that the exit value is more than 1x, an investor may opt to convert to common so they can participate using their full ownership percentage.
PIKs and Cash Dividends or Cumulative Dividends
Paid in Kind (PIK) and cash are two types of cumulative dividends. Out of the two, cash is the most common. Cash and PIKs both act like interest where there are terms that define the amount of that accused and the accrual method (i.e. compounded interest) used.
They are generally paid during a liquidation event and will accrue interest until it occurs. PIK dividends are paid in shares and these can increase over time. Therefore you could have a case of broad ownership dilution when using this term.
Participation Rights and Caps
The simplest way to explain participation rights is that enables a shareholder to keep all their preferential terms while acting like common stock. It is a very advantageous position to be in as a shareholder. There’s usually a cap that’s involved with having these participation rights. For example, it’s common for the cap to be at 2x or 3x of the investment. If there isn’t a cap, a shareholder can dilute other shareholder’s equity value while receiving their preferred stock benefits and being allowed to participate forever with common.
How to Minimize Equity Dilution
Equity dilution is not a bad thing, despite the common negative implications that it triggers. It’s a necessary part of virtually every startup’s business. Being about to grow your business to the next stage can only be done with the necessary funds to fund it.
That being said, you don’t want to dilute your equity more than necessary because it will affect your control and rewards as your startup takes off. Here are some ways to minimize your equity dilution during the early stage of your start-up:
Raising Less Money to Give Up Less Equity
Just because you can get $10 million in investment doesn’t mean you should. Remember, the most “expensive” money you’ll receive is the initial money you receive to get your startup off the ground. Being greedy during the early stages puts you at more risk at risk of becoming fully diluted, missing the rewards that you could have received later on.
Therefore, determine how much investment money you need up-front. Figure out as accurately as possible how much money you need for your business to be taken to the next step. Also, you don’t have to agree to more cash if an investor offers it. Decide if there are needs that could be filled during your initial evaluation and base your answer on that information.
Investors who want protection from equity dilution can have clauses built into their convertible preferred stocks and even some options that are built-in.
These act as a buffer to provide protection from their equity ownerships becoming diluted or reducing their value. One of the common ways this occurs for investors is when new shares of the company are issued during these startup series of founding.
Tweaking the conversion price between convertible securities like preferred shares and common stocks helps to discourage this dilution. That way, investors can continue to keep their original ownership percentage.
Reference your Cap Table
Your capitalization table describes the number of shares (percentage of ownership) that every investor in your business has. You should review your cap table regularly, particularly during these initial stages of your company.
When considering different funding options, use your caps table to help you project the effects of each scenario. You should get a better idea of how much dilution may occur if you’re considering another funding round to your existing shareholders as well as how it may impact future profitability.
Don’t Allocate too much in your Options Pool
It is tempting to give your loyal, hard-working employees a higher stake in the company by offering up equity. Many startups do this as a substitute for a higher salary and because it may help attract certain people to work for you. But you can end up allocating too much money to your employee equity pool.
Try to reserve a certain pool of options for your employees and allocate it with the staff you need.
As your startup moves to later stages, make sure to review your options too and make adjustments as necessary.