Startups are fairly binary in their ability to create wealth for all stakeholders. More often than not, they go bust but when things go right, you can spend the rest of your life on a beach 🏖️.
One of the primary ways startups finance their growth is by issuing equity to investors in exchange for capital.
However, as the company grows, there are various factors that can lead to equity dilution, which can affect different stakeholders in different ways.
What is dilution?
Equity dilution occurs when a company issues new shares, reducing the percentage ownership of existing shareholders. In the context of startups, this usually happens when a company raises additional capital through funding rounds. The new investors receive new shares, and the existing shareholders' ownership percentage decreases proportionally.
Take this scenario for instance: two people start up with each having 50% of all shares. Assuming that they are raising funds from investors by giving up 20% of the shares after allocating 20% more for the ESOP pool.
The resulting ownership structure would look like this:
Founder A | 32% |
Founder B | 32% |
ESOP Pool | 16% |
Investors | 20% |
Who does it affect?
Short answer: everyone on the cap table.
For employees with stock options, when a company issues new shares, the value of the existing shares may decrease, diluting the value of the employee's options.
For example, suppose an employee has options to purchase 1% of a company's shares at $1 per share. If the company issues new shares and the total number of shares increases from 10,000 to 20,000, the employee's options now represent 0.5% of the company. If the company's valuation remains the same, the options are now worth $0.50 per share, rather than $1 per share.
However, this typically doesn’t occur as most startups raise funds at a higher valuation with each subsequent round, meaning the overall value of the shares go up, despite the dilution.
The same rules apply for investors too.
But in this case, there may be special provisions to help protect their interest and maximize returns. For instance, investors often negotiate for preemptive rights, giving them the right to purchase additional shares in future funding rounds to maintain their ownership percentage.
Minimising Share Dilution
As a founder to have skin in the game for the long run, it’s important to take steps and minimize how much equity you give up.
Creating an option pool
For instance, during your first institutional funding round, investors will instruct you to create an option pool for employees. While this is a standard approach to ensure their equity is not diluted in the future owing to employee grants, remember that the entirety of this pie will come off of your share of the company.
Whether it is 20% or 10% can go a long way to determining your share of equity in the future.
How much do you need, and why?
As a founder, it is easy to get enamoured by all the money that VCs and investors have to offer. But every dollar comes with a price and it is for you to answer how much equity you are willing to give up early on.
If you end up with single-digit percentage ownership of the company by the time you are raising a Series C, would you be motivated to build the company the same way as when you started?
Creating a roadmap of how and where you intend to spend the funds can help you figure out how much you need to raise, and consequently, how much of company ownership you are giving away.