The big elephant in the room we all experience in the startup investing world is dilution. No one wants to admit they’re thinking about it, but it’s on the minds of founders, VCs, and LPs alike. It can cause a decent amount of attention especially during financing rounds.
Dilution is a reality for any startup facing funding. Of course, as a founder, you start off with 100 percent ownership of the company, essentially every share. However, with each wave of fresh capital, as well as employees looking to be compensated with stock options, new shares are issued and that percentage ownership of the company shrinks. When new shares are issued, those who already own shares end up owning a smaller, or diluted, percentage of the company. The more total shares held by investors in a company, the less percentage ownership each existing shareholder possesses.
Dilution is not necessarily a good or bad thing, it just is a thing. It’s important to understand dilution and the dynamics behind it so you can have a solid understanding of how investments may pan out and how to protect them.
This is why the stage of investment matters and why investors at different stages are going to negotiate and approach the funding opportunity differently. As a founder, you need to understand this dynamic and respect the fact that every round of funding looks a little differently.
There are other ways dilution occurs outside of the obvious explanation given above. Convertible instruments, such as simple agreements for future equity (SAFE) and convertible notes offer up future preferred stocks to investors in earlier funding stages. Priced rounds and stock options also can lead to dilution.
Is Dilution a Concern?
Keep in mind that dilution can sometimes be a good sign for a company. Most companies will need multiple rounds of fresh capital to support their growth and get to a profitable state. More money coming in generally means higher valuations and higher value of your stake. If a company is doing really well, a percentage or two can make a major difference, and any investor is going to want to maintain as much equity in order to profit upon exit.
Many investors will want a “right of first offer” and negotiate this into their initial investment. This allows investors to participate in future rounds should they like. Usually investors will want to have anti-dilution provisions built into the agreement to reduce the Conversion Price. Another common practice is to leverage weighted-average anti-dilution.
Your ultimate goal is to see your investment increase in value even if your percentage of ownership decreases. Keep the big picture in mind, especially as you are talking about fine details within a funding round with potential investors. Check the emotions at the door and look at the numbers and the potential numbers that result from the percentages you might be giving out.
Understanding Dilution from an Investor’s Perspective
The big elephant in the room we all experience in the startup investing world is dilution. No one wants to admit they’re thinking about it, but it’s on the minds of founders, VCs, and LPs alike. It can cause a decent amount of attention especially during financing rounds.
Dilution is a reality for any startup facing funding. Of course, as a founder, you start off with 100 percent ownership of the company, essentially every share. However, with each wave of fresh capital, as well as employees looking to be compensated with stock options, new shares are issued and that percentage ownership of the company shrinks. When new shares are issued, those who already own shares end up owning a smaller, or diluted, percentage of the company. The more total shares held by investors in a company, the less percentage ownership each existing shareholder possesses.
Dilution is not necessarily a good or bad thing, it just is a thing. It’s important to understand dilution and the dynamics behind it so you can have a solid understanding of how investments may pan out and how to protect them.
This is why the stage of investment matters and why investors at different stages are going to negotiate and approach the funding opportunity differently. As a founder, you need to understand this dynamic and respect the fact that every round of funding looks a little differently.
There are other ways dilution occurs outside of the obvious explanation given above. Convertible instruments, such as simple agreements for future equity (SAFE) and convertible notes offer up future preferred stocks to investors in earlier funding stages. Priced rounds and stock options also can lead to dilution.
Is Dilution a Concern?
Keep in mind that dilution can sometimes be a good sign for a company. Most companies will need multiple rounds of fresh capital to support their growth and get to a profitable state. More money coming in generally means higher valuations and higher value of your stake. If a company is doing really well, a percentage or two can make a major difference, and any investor is going to want to maintain as much equity in order to profit upon exit.
Many investors will want a “right of first offer” and negotiate this into their initial investment. This allows investors to participate in future rounds should they like. Usually investors will want to have anti-dilution provisions built into the agreement to reduce the Conversion Price. Another common practice is to leverage weighted-average anti-dilution.
Your ultimate goal is to see your investment increase in value even if your percentage of ownership decreases. Keep the big picture in mind, especially as you are talking about fine details within a funding round with potential investors. Check the emotions at the door and look at the numbers and the potential numbers that result from the percentages you might be giving out.