As a startup that is raising capital, the amount you own today of your company will decline depending on how much capital you raise, how many times you raise, your pre-money valuations and any investor preferences along the way. This is known as dilution and being able to map this out from day one and in multiple scenarios is important so that, as a founder you can protect your equity (possibly).
As more funding rounds occur, early investors will also become diluted – not just the initial founders. There are key dilution definitions each founder needs to fully understand.
Keep in mind that there may not be anything you can do to prevent yourself from being diluted over time. That said, it’s still important to understand this on the front end so you’re not surprised down the road.
- Number of Shares – The number of shares you have, out of the total shares that have been issued, makes up your ownership percentage. So, the fewer shares you hold, the less you own of the company. In that way, it’s clear why this term plays a big part in how much dilution you see on your cap table.
- Liquidation Preference – A liquidation preference gives shareholders first dibs during liquidity. It means that shareholders with a liquidation preference get their money before anyone else gets anything at all. Typically, you’ll see a 1x liquidation preference, which guarantees investors will at least break even and receive their initial investment in full before common shareholders start participating in the distribution.
- Rate of Conversion to Common – This term only applies when preferred stock is exchanged for common stock during a distribution event, like an exit. The term allows a shareholder to convert their shares to common at a multiplied rate, like 2 times what they initially held. Even though preferred stock comes with certain negotiated advantages, it is sometimes more beneficial for an investor to forego their preferential stock and participate in common stock. If that’s the case, the shareholder will waive all their preferred rights.
- Participation Rights and Caps – These allow a shareholder to act like common stock while keeping all their other preferential terms. Remember earlier we said preferred shareholders that wanted to convert to common had to waive their preferred stock rights once they convert? Well, not if they have participation rights. They will get the best of both worlds. A participation right usually includes a cap, meaning they receive all the benefits of their preferred stock and then go on to participate as common stock with a threshold. A participation cap will often be 2x or even 3x the investment.
- Cumulative Dividends (PIKs and Cash) – There are two kinds of cumulative dividends, Paid in Kind (PIK) and cash. Both of these act as a form of interest with set terms for how much accrues and how that accrual method is calculated, like simple or compounded interest.
- Anti-Dilution – While anti-dilution sounds like a good thing, it can actually be one of the most aggressive causes of widespread dilution. Anti-dilution acts as a cap, preventing shares from being diluted past a certain point. Essentially, anti-dilution works to protect shareholders from future rounds of funding where the price per share is lower than the original price an investor paid, also known as a down round. During a down round, you can see your ownership percentage shrink dramatically. Find out more about anti-dilution here.
Real World Example of Founder Dilution
As an example, let’s assume a pre-money valuation of $4,000,000 for a company undergoing its first round of venture capital financing. If the investors were to commit $4,000,000, these amounts would result in a post-money valuation of $8,000,000 and the investors would receive 50% of the company on a fully-diluted basis. In this scenario, founders often assume that the founders would therefore own the remaining 50% of the company post-closing.
However, depending upon the current composition of the management team (and current stock positions of each member), the investors will typically expect a stock option pool to be implemented immediately prior to closing to reserve stock for future issuances to new hires, allowing the company to round out the management team. This option pool is usually established prior to closing so that the investors are not diluted.
Although the size of the option pool is a subject of negotiation, a typical option pool might reserve 20% of the stock of a company on a fully-diluted basis. Therefore, in the above example, instead of the founders owning 50% of the stock after the Series A closing, the founders would instead own only 30% of the equity on a fully-diluted basis (with the investors owning 50% and 20% reserved for the stock option pool). (MBBP.com)
Of course, these percentages will change with each round of fundraising, further diluting the equity of the founders. To determine what those may be, and how the value of your equity may grow despite founder dilution, you can use the following dilution calculators:
CEO & Founder
Source: Wall Street Journal
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