Founders - Understanding Dilution Is a Must!
Equity dilution is something that all startup founders must fully understand. Failure to do so could see the stake in the company they were responsible for founding greatly diminish.
It is also the case that when looking for a cash injection founders see share dilution in their company as the only path open to them. This is particularly the case if they are lacking upfront investment.
While accepting that equity dilution is a very popular way for founders to secure essential funding it is not the only route.
With these factors in mind, let’s take a look at:
- What equity dilution is.
- How it is calculated.
- How it can affect founders as their fundraising efforts progress.
- The pros and cons of equity dilution for founders.
- Some alternative solutions that can help founders raise minimally-dilutive capital.
Let’s get started with:
What is Equity Dilution?
As the term suggests, equity dilution happens when the ownership stake a founder has in their startup is reduced. This occurs as a result of issuing new shares in the company and often follows an investment.
An example is, a founder agreeing to sign over 20% of their company in shares to an angel investor in return for the investment amount given. From there, and through additional investment in future funding rounds, founders can see their equity share in the company further diluted.
It is also common for founders to offer equity or shares to company employees to begin fundraising efforts.
As briefly mentioned, equity dilution is very common within the startup world. This is because the majority of founders are not blessed with lots of money when beginning their startup journey.
It then follows that once a founder has validated a product or service that they need investment funds to bring it to market. From there, this funding will be used to scale and grow their business healthily and sustainably.
To achieve the above, one of the most common (and easiest) ways to do this is to offer equity in the company in exchange for investments.
The reason investors see benefits in taking a share of a company is clear. They are aware that a startup is unlikely to have the money to directly pay back the funds given.
With that in mind, investors are prepared to take a percentage ownership of the company. This is done with the hope and expectancy that the business will achieve future success and thus bring in greater revenue which they will share in.
How Equity is Diluted and Why Founders Need Caution…
Company ownership is broken down by the number of shares owned. When a startup is formed it is usual for the founders to own 100% of their company’s shares.
To give a straightforward example, let’s assume that ownership is 100 shares.
As the founder successfully raises capital, they give equity to those investors putting funding into the business. In this case, they give 50 shares.
This means that the founders still own the same 100 shares but the 50 shares given to investors have now been added to the overall pool.
The introduction of these new shares takes the founders' ownership stake from 100% – (100 shares/100 total shares) to 66% - (100 shares/150 total shares).
If additional capital is required by the founders and is successfully raised at the expense of giving up further equity in the company this continued dilution can become a real issue for the founders.
Any founder that allows their equity stake to drop below 50% of company ownership is at risk of losing control of the company’s future direction and voting power. With that stark warning, it is very clear that founders need to protect themselves against over-dilution.
At What Stages Does Equity Dilution Occur?
Founders will find there are 3 common stages subject to equity dilution. Let’s look at each in turn:
- Fundraising: Raising new capital often sees equity given to the investor(s) concerned. This is seen as the investors' source of return.
- Convertible Debt: This is a debt structure. It allows the principal as well as accrued interest to be converted into an equity investment at a later ‘trigger’ date.
Trigger event examples are fundraising rounds or an exit. If the convertible debt is triggered this converts debt holders into shareholders. The result is that the ownership stake which is held by the initial shareholders is diluted.
- Stock Options: Stock options do not result in the immediate issuance of new shares. However, by implication, holders of stock options will become future equity holders. This occurs once those options are exercised.
The Pros and The Cons of Equity Dilution
Founders should be aware that equity dilution is not necessarily a bad route to take when looking for a cash injection to grow their company. However, the positives and the negatives of equity dilution need to be clearly understood.
Here are some of the most important equity dilution pros and cons to be aware of:
The pros of equity dilution
- When structured correctly it is a good deal all around.
- Founders secure the capital funding they need to take their business forward.
- Because investors have a stake in the company they are committed to helping it grow.
- While a founder’s equity stake may be considerably lowered. It is still very likely that they ultimately secure more money for themselves than they would do without investment.
The cons of equity dilution
- By its very nature founders must give up some of their company ownership.
- Founders lose a certain amount of control over the future of the business.
- There are alternative ways for founders to secure investment. These can be achieved without giving away part ownership.
Two Main Ways That Equity Value can Change
While several variables can change equity value the two main ways in which it can vary are Monetary and Ownership.
Founders need to take time out to understand the value of their equity for two reasons. First, it can help them secure greater investments. Second, it accurately shows just how much of their company they are giving away.
With that in mind, let's take a look at terms that reduce monetary value and ownership percentage.
Terms That Reduce the MONETARY Value of Shares
Here are 3 terms that will reduce the monetary value of shares:
This gives shareholders priority during liquidity. Meaning, any investor with preferred shares status gets their money back before anyone else (common shareholders).
When agreeing to an investor term sheet founders should look closely at the liquidation preference clause. Anything higher than 1x is increasing the likelihood that some investor returns will either be greatly diminished or they will completely miss out should the company be liquidated or sold.
These rights represent an agreement between the startup and an investor(s) whereby the startup gives the investor the right, but not the obligation, to participate in one or more funding rounds.
While this is seen as a ‘best case’ investor scenario, startups do not typically award such rights to all investors.
This is the most common way that shareholders receive cumulative dividends. They are a form of interest that comes with a set of agreed terms stating how much is accrued during a shareholder's term.
Terms That Reduce PERCENTAGE Ownership
Here are 4 terms that will reduce the percentage of ownership:
The Number of Shares
The greater number of shares a shareholder has, the more they own in the startup. If the startup has issued a lot of shares to a lot of shareholders they will need to please a lot more people.
Conversion Rates to Common Stock
This conversion applies when preferred stock is exchanged for common stock and occurs during a distribution event. This gives shareholders the opportunity to convert their shares at a multiplied rate.
Payment-in-Kind (PIK) Dividends
Along with cash, PIK dividends are another form of cumulative dividends. However, unlike cash dividends, PIK dividends increase the share numbers given over time.
An anti-dilution clause acts as a cap because it prevents the dilution of shares past a certain point. This is seen as being beneficial to shareholders because the startup will not go through future funding rounds where the PPS (Price Per Share) is lower than the original price shareholders have paid.
Common Stock vs. Preferred Stock - Be Aware of the Difference
It is crucial that founders fully understand the difference between common stock and preferred stock as this will affect equity dilution.
The major difference between the two is that preferred stock comes with additional rights. Common stock is generally given to founders and employees. However, investors who have negotiated preferred stock options have advantages.
This is because they can negotiate certain preferred terms. These preferential terms can either directly convert their shares into common stock or allow them to participate with common stock while not giving up any of their agreed preferred rights.
Founders Should Avoid These Equity Dilution Mistakes
Here are 5 factors that founders must keep in mind if they are to avoid getting into a potentially damaging equity dilution situation:
Raising more capital than is required
Understandably, many founders feel the more funding they can raise, the better. However, this is not the case and caution is required during funding round negotiations.
Founders should carefully calculate the amount of funding they feel is required to grow their business in a sensible and structured way to their next milestone (and add a sensible amount of ‘fat’ to cover any unforeseen future expenses). That figure is what founders should be looking to raise.
Raising more capital than is required can lead to inefficient spending, distract you from your business strategy, and mean greater pressure from investors who will want to see far faster results.
Constantly keep an eye on your capitalization table
Your capitalization (Cap Table) is a crucial part of a startup's business. It shows the number of shares as well as the ownership percentage per shareholder.
Smart startup founders will use a secure, online cap table to manage critical company data. Effective utilization of your cap table is also a very useful tool when it comes to managing ownership data in a growing company.
A flexible, easy-to-use online cap table will also help founders in many other ways. Just two excellent examples are:
- Modeling how a variety of different funding options could impact the dilution of existing shareholders and profits per share.
- Model the impact effect of a succession of future funding rounds. This can provide insight into your overall business plans and work to identify possible exit scenarios.
Choose your investors carefully
Founders need investor funding but the investor(s) being considered must be right for your startup. This means research and due diligence on any potential investor is a must. You need to identify the type of investor that is right for your business.
Every investor will have their own ‘rules’ as to the investment opportunity they are looking for. This will include the percentage of the company they expect to own in return for funding. Understanding exactly what each investor’s criteria are will increase your chances of finding one that is right for your company and business goals.
Ignoring alternative funding options
While parting with equity is a popular way to raise funds it is not the only option. Founders can look at fundraising through venture debt or revenue-based financing that offers capital for growth while minimizing equity dilution.
It may well be the case that you need to dilute equity to raise the necessary funds. However, understanding other alternatives and having a firm idea of what portion of your company you are prepared to give away will leave you in a far better position when it comes to the fundraising process.
Never forget your business focus
Before pitching to any investor you should have a clear business plan and couple that with realistic numbers that minimize dilution. From there, the more compelling your pitch presentation is, the more likely you are to attract the interest of competing investors.
Achieve that and you will be in a stronger position to get a better valuation, raise the amount of funding you are looking for and have additional leverage to reduce dilution.
Make the Most of Equity Dilution by…
Before our closing comments on how founders can effectively manage equity dilution, here are 4 key details that can help you keep equity dilution to a sensible level:
- Carefully calculate the amount of funding required to reach your next growth milestone.
- Seek investors who are aligned with your business goals and those you can trust.
- Take full advantage of your online cap table to regularly review and model different scenarios.
- Do not allocate too large an employee equity pool. As a rule of thumb, most startups reserve between 10% and 20% of equity for their option pool.
Equity Dilution - Founders Should Seek Assistance
How founders handle equity dilution will determine their overall ownership stake in the company they have worked long and very hard to create.
If this major issue is not handled correctly it can very quickly snowball. So much so that founders could be left with a minority stake and loss of control in the venture they put so much into
There are so many factors to consider and decisions to be made relating to equity dilution. This means it is essential for founders to seek knowledgeable advice as early in their startup journey as possible.
WOWS Global is ready to offer such guidance. Our highly experienced team of professionals has in-depth knowledge of the startup world and is ready to assist founders in every step of their journey.
Our state-of-the-art, secure digital ecosystem is available to support you. This investment readiness platform is designed to meet your startup's every need.
One strand of our service is to simplify equity management. This is achieved through secure access to our digital cap table management tool. Amongst other things It is designed to allow founders to:
- Seamlessly manage equity.
- Increase transparency for stakeholders.
- Always be due diligence ready.
- Run deal scenarios.
- Calculate dilution impact.
WOWS Global is on a mission to ensure startups get the best possible advice to suit their individual needs. We also have the capability to bring together like-minded startups and investors for long-term, healthy relationships.
Any founder that would like to find out more should reach out to us for a no-obligation discussion at: