Equity Dilution: What Pre-Seed Startups Need to Consider
Many pre-seed startups struggle with the question of how to allocate stock options. On the one hand, they want to attract and retain top talent. On the other hand, they don’t want to give up too much equity too soon. This can lead to tension and even conflict within the founding team. Therefore, one of the most crucial elements that startup entrepreneurs must consider is equity dilution.
Think about how much equity you’re willing to give up for future funding rounds. As your company grows, you’ll likely need to give up more and more equity to attract investors.
It’s critical to consider how much equity you’re comfortable giving up and what kind of control you want to maintain over the company. By taking some time to understand the issue and plan for it accordingly, you can minimize its impact on your startup.
This article will discuss equity dilution and what pre-seed startups need to consider in order to mitigate it. We’ll also talk about ways to protect yourself from dilution and maintain control of your company if you need to raise additional capital.
What is stock or startup dilution?
Startup dilution is when a startup founder’s ownership stake in the company is reduced after raising money from investors. This can happen in several different ways, but the most common is when a startup sells equity to investors in exchange for funding. The amount of dilution will depend on how much money is raised and at what valuation.
Since Stock dilution is a term used to describe how startup founders can experience a decrease in their equity percentage as the startup grows and raises additional funding, it’s essential to consider how it impacts key stakeholders.
Thus, while it may be seen as a disadvantage from one perspective, from another perspective, startup dilution is a necessary part of growing and attracting additional capital for future expansion.
Understanding common dilution scenarios
One common dilution scenario for startup founders occurs when the company creates a stock options pool. This stock is set aside for employees, and it typically comes from the founders’ equity. As a result, the founders’ stake in the company is reduced; they can calculate equity dilution by taking the pre-money valuation and accounting for the equity they sold for the new capital.
For example, let’s say a pre-seed startup has a pre-money valuation of $500,000, and the founders own 80% of the company. They set aside 20% of the company for a stock option pool, which leaves them with 60% ownership. If they sell 40% of the company to an investor in exchange for $200,000, their post-money valuation would be $700,000.
The equity dilution formula would look like this:
Equity Dilution = (Pre-Money Valuation – Post-Money Valuation) / Pre-Money Valuation
Equity Dilution = ($500,000 – $700,000) / $500,000
Equity Dilution = 0.40 or 40%
This means that the founders’ ownership stake in the company has been reduced by 40%.
Another common dilution scenario happens when a company raises money from investors, and the new investment dilutes the existing shareholders’ equity.
However, it’s important to note that dilution is not always bad. It can be necessary to raise money to grow the business in some cases. And in other cases, it may be possible to negotiate terms that minimize the dilution to the founding team.
For example, a founder could agree to accept a lower salary in exchange for a more significant equity stake in the company. How much equity, however, would be subject to the investor agreements.
Causes of stock dilution
When a company’s stock price decreases, the value of each individual share also decreases, known as stock dilution. There are several reasons why a company’s stock price might decrease, but one of the most common is issuing new shares.
Whenever a company issues new shares, it essentially dilutes the value of existing shares. There are now more outstanding shares, so each one is worth less than it was before.
Other causes of stock dilution include share repurchases (when companies buy back their shares) and convertible debt (which can be converted into shares).
While stock dilution can be frustrating for shareholders, it’s important to remember that not all dilution is terrible, and it can be a good thing for many companies.
For example, issuing new shares can help a company raise capital to invest in growth. So, while it’s essential to be aware of the causes of stock dilution, it’s also helpful to examine the reasons behind any instance of dilution before making any judgment.
One way to measure equity dilution is the “equity pie.” An equity pie is a tool for visualizing how valuable resources are shared in a company or organization. It is designed to help stakeholders, such as employees and customers, understand how different groups relate to each other and the resources being used.
At its most basic level, the equity pie uses proportional symbols to represent different aspects of value, such as revenue, profits, operations expenses, or owner’s equity. By understanding this information, an equity pie can serve as a valuable tool for helping individuals understand how the resources used in their daily lives are shared between various stakeholders.
As startup companies issue new shares, the equity pie gets smaller, so naturally, each slice decreases. This can be problematic for startup companies because it can reduce voting power and control among existing shareholders. Therefore, equity dilution is an essential factor to consider when deciding whether to do a full capital raise.
Is stock dilution worth accepting a new investment?
At its core, stock dilution refers to the increase in the number of shares outstanding post-investment, leading to an overall decrease in the value of each share. While this may seem disadvantageous at first glance, several important aspects of stock dilution make it worth considering.
For one thing, diluting existing stock allows the company to raise capital and expand operations without giving up control of the business. At the same time, accepting an influx of new investors also gives a company access to valuable resources or opportunities for increased collaboration and networking.
In other words, by accepting a new investment, pre-seed companies are essentially giving up some of their equity in exchange for funding and resources that can help them grow and succeed.
While some may see this as a necessary sacrifice, it is essential to remember that there are ways to mitigate stock dilution. For example, pre-seed companies can take steps to calculate both post-money valuation and equity dilution to evaluate whether the benefits of a particular investment outweigh its costs.
By doing so, these companies can avoid investing in partnerships that might be detrimental to their long-term success. Although stock dilution may feel like a daunting and inevitable risk for pre-seed companies, careful planning and decision-making can help minimize its impact on post-money valuation and equity dilution.
Why do founders choose to reduce stakes?
Many founders choose to reduce their stakes in their startups early on to gain post-money valuations. This is done by calculating the stock dilution based on the number of shares issued and the post-money valuation.
By taking such factors into account, founders can get a clear sense of their current stake in the company and whether it makes sense to reduce it or not.
Ultimately, reducing one’s stake in a startup depends on individual factors, including whether they believe increasing post-money valuations is worth reducing the equity in the long term.
Even if founders opt for reduced stakes or not, what’s most important is ensuring that their startups continue to succeed and grow over time.
Is stock dilution good or bad?
A pre-seed startup is a company that has not yet generated any revenue and is typically in the early stages of product development.
To grow, pre-seed startups often need to raise money from investors. One way to do this is through equity dilution, which can be used to finance growth or pay down debt.
Dilution is a two-way street
Many people view stock dilution as a negative term. When you look at it more closely, however, there are both benefits and drawbacks.
First, let’s look at the bad. When a company issues new shares, it reduces the value of the existing shares. This can be a problem for shareholders, as their investment is now worth less than before. Additionally, if a company dilutes its stock too much, it can become difficult to raise money in the future by selling new shares.
Now let’s look at the good. When a company issues new shares, it also raises new capital. Issuing new shares can help to incentivize employees and provide them with a stake in the company’s success. Also, it can help to pay down debt. By selling new shares, a company can raise money to pay off outstanding loans or other debts.
As you can see, there are both good and bad aspects to stock dilution. Ultimately, whether it is a good or bad thing depends on the company’s circumstances.
Company Share Structure
Companies seeking to raise money to build their operations and expand their reach need to devote time to developing an easy-to-understand capital structure. These companies typically have a dynamic share structure determined by various stakeholders, including investors, employees, and key partners.
Classify Your Shares
Typically, pre-seed companies will offer preferred stock to potential investors, which gives those investors specific ownership stakes and other benefits.
Pre-seed companies may also issue additional shares of stock to existing investors or business partners to reward them for their contributions.
All in all, pre-seed companies are highly focused on economics and value creation, so they need to be strategic when determining the terms of their share structure. This allows them to manage risk while ensuring that they can attract the capital they need to succeed.
How does startup equity dilution work in different funding rounds?
Funding rounds are an essential component of startup capital raising. Most startup companies require capital to get off the ground, and diluting startup equity is how founders can raise money. For example, a startup may sell 20% of its equity for $1 million in a seed round of funding.
This means that the startup’s current shareholders will own 80% of the company, and the new investors will own 20%. As a startup raises more money in subsequent funding rounds, it will continue to dilute its equity.
Keep An Eye on Your Agreements
Existing investors usually have the option to maintain their ownership stake by investing more money in the company. As a result, they often have a larger share of the company than they would have if they had not invested additional funds. This process of diluting startup equity can be complex, but it is an essential source of capital for many young companies.
How can investors mitigate the effects of dilution?
For a startup to grow and sustain itself, it often needs to raise money from investors. While this can be an effective way to get the necessary funding to expand and scale, it also carries some risks. One of the most critical risks that investors face is dilution or the loss of equity due to new investment rounds.
To mitigate its effects, investors need to be aware of key factors such as startup equity and how much they are willing to spend on seed rounds.
Additionally, they should consider working closely with other existing investors to avoid unnecessary competition. By doing these things, investors can help to reduce their risk exposure and make the most out of their investment opportunities.
Here are some guidelines to help make the most of your funding round without being too diluted:
1. Limit options pool
To avoid being “diluted” and having your stock pool diluted in a funding round, it is crucial to be selective about your partner investors. Specifically, try to focus on investors whose philosophies align with your values and goals for the company, as well-aligned investors will be more likely to support you throughout the growth process.
One way to limit the options pool is to conduct a seed round of funding before launching the startup. This allows the founders to gauge interest and assess valuations before raising money from a larger group of investors.
2. Be wary about raising too much money
Another crucial guideline when raising funding is to be mindful of how much money you need and when you need it. While there are many well-known success stories of startups securing huge rounds early on and going on to be highly profitable, this is not the right approach for everyone. Rather than aiming for the biggest possible pool of stock dilution, it can be more effective to raise smaller amounts at key points in your company’s development and use those funds wisely.
3. Stay educated and informed on agreement terms
It is essential to be aware of any potential anti-dilution mechanisms included in funding agreements, such as warrants and options. These tools give investors more leverage over your organization’s stock if things don’t go as planned further down the road. Hence, it is crucial to understand them fully before committing to an agreement with potential investors.
4. Don’t be afraid to negotiate
Investors know that startups are often desperate for funding, so don’t be afraid to negotiate for better terms. Negotiations serve several different purposes, one of which is to help avoid stock dilution. The more investors involved in a funding round, the greater the potential for stock dilution.
Investors often want some control over their share of the company, resulting in changes to stock percentages and ownership structures that can ultimately affect your stake in the startup.
By negotiating early on with potential investors, you can ensure that you are not being diluted without your consent or knowledge. This can help protect your position as an entrepreneur and give you greater peace of mind as you move forward with your company’s growth.
Final Thoughts
Equity dilution is a natural risk that comes with investing in startups. By better understanding the topics discussed, startup founders can ensure that they can raise the necessary capital without giving up too much equity.
M Accelerator Cohorts
The M Accelerator’s Startup Program is an excellent resource for startups looking to raise money. Our program helps founders in gaining more clarity on their go-to-market strategy, and funding strategy and for qualifying teams, M Accelerator provides access to investors and financial institutions, allowing entrepreneurs to raise capital from various sources.
If you are at an earlier stage or you are planning to launch your business in 6-10 months, join our Founders Meetings and see what a healthy fundraising strategy looks like.
Additionally, the Founders Cohort and the Startup Program provide mentorship and advice from experienced startup investors, helping entrepreneurs navigate raising money. If interested, this is an invaluable resource for startup companies seeking to raise capital in the early stages of their development. Join our Founders Meetings to learn more.