Dilution: Explained

For instance, valuation and dilution are two intricately linked fundamentals, and all founders should have some understanding of the relationship between them. Since your valuation will eventually determine your dilution, your overall objective is to maximise valuation while minimising dilution. While this may sound straightforward, it can quickly become very complicated as you grapple with the difficult ins and outs of fundraising.

What is Equity Dilution?

Put simply, equity dilution is the decrease in equity ownership of existing shareholders that happens each time you issue new shares, like when fundraising or creating an option pool.

For example, imagine you are the sole owner of company X and you own 20,000 shares. You decide to create an option pool of 3,000 shares for future employees. You also give an investor 7,000 shares in return for their investment. In total, there are now 30,000 shares of company stock and you now own only 66% of your company.

Dilution can change both your financial stake in the company and the level of control you have, so it’s important to understand how raising money can impact your ownership, especially early on. Some form of dilution is virtually inevitable in the modern investment landscape – e.g. most industry experts estimate that founders will sell 20 to 35% of their company during their series A round. This does not mean you need to be afraid of it, it is however essential that you understand it.

Standard Equity Rounds

In a standard funding round, investors give you a certain amount of money for a certain number of shares based on the company valuation you agree upon with your investors.

In addition to the dilution that happens when you issue shares to your new investors, early funding rounds, like Series A, are also when your past decisions usually come into play. This is the case with SAFEs for example, which we will discuss later.

Pre-Money vs. Post-Money Valuation

Whenever you raise money in a round, whether the valuation you and your investor agree upon is your pre-money or post-money valuation will impact how much any new investment will dilute your ownership so it’s important to know which one you’re using before raising.

For instance, if your investor gives you £500k for a valuation of £2 million. If that £2 million is your pre-money valuation, that means you own 80% of the company after the investment (500,000/2.5m = 20% given away). However, if that £2 million is your post-money valuation, you only own 75% of the company after the investment (500,000/2m = 25% given away).

SAFEs

A SAFE (Simple Agreement for Future Equity) can be a convenient way to raise financing during the early stages of your company. However, beware of the dilution that can result from SAFEs.

A SAFE is a type of convertible instrument that allows you to raise money from an investor now in exchange for future shares in your company. In exchange for investing, your SAFE holder gets shares from your next round of financing, often with favorable terms (such as a discount). These favorable terms help attract investors and act as a reward for the additional risk that comes with investing at a very early stage.

How does dilution work with a SAFE?

SAFEs essentially allow you to postpone dilution until your next financing round. This may make it tempting to immediately accept the terms of a SAFE. However, you must consider the dilutive power of SAFEs because deciding to raise convertible instruments early on could have a major impact on your ownership in the future.

While many factors can influence how dilutive SAFEs will be, there are three main things you should bear in mind:

• Pre-Money vs Post-Money SAFEs – with pre-money SAFEs, each investor’s ownership percentage is uncertain until you raise your next round. This may be less dilutive for you, the founder, since everyone’s ownership gets diluted at the same time. With post-money SAFEs, investors lock in the percentage of the company they’ll own before the new investors get mixed in. Many investors prefer this type because it gives everyone a better idea of where they’ll land in terms of ownership.
• Valuation caps – a valuation cap is the maximum valuation (of the share price) at which your investor’s money converts into equity. Therefore, if your company valuation at Series A is higher than your SAFE valuation cap in an earlier round, your SAFE investors will receive a lower price-per-share than the Series A investors, giving your SAFE investors more shares for their investment.
• Conversion discounts – a conversion discount gives your investor a discount on the price per share when their SAFE turns into equity. For example, if your Series A investors are paying £1 per share, your SAFE holder may only have to pay 80p per share.

Measures you can take to minimise dilution

It’s important to remember that every decision you make involves real money and can have a real impact on how much you own and what you are entitled to when you eventually sell your company.

While some level of dilution is unavoidable, there are some strategies you can take to minimise it:

Plan properly. You need to understand how much capital you need not just for this round but ideally for later stages as well. Not planning now will hurt you later.

Don’t raise more than you truly need to get to the next stage of your business. The money you raise early on in your company is the most dilutive. Since early investors are receiving equity at a time when your company is worth comparatively less, each pound they invest buys a proportionally larger piece of your company pie. Of course, this does not mean that you shouldn’t raise or raise less than you need. Be sure to forecast accurately and aim for an amount that will realistically help you achieve your original operating plan and get you to the next stage of your business.

Don’t rely on notes for too long. Note and SAFE holders often receive favourable terms on their investment as we discussed earlier so you don’t want to use them too many times.

Don’t create a bigger option pool than you need. Investors may ask you to allocate more than you need to reassure them that your key employees will remain loyal to the business, but if you create a hiring plan, you can demonstrate how you came up with your ideal pool size.

Don’t rush. It is essential that you read the Terms & Conditions of a term sheet or SAFE, take the time to understand it, and consider the long-term implications before you sign.

Model your future dilution. Don’t get caught by surprise with a dilutive impact you weren’t expecting. It’s usually too late to do anything about it. If you’re considering fundraising, it’s so important to model the impact of dilution first. The ideal way to model future dilution is to use a CAP table. A CAP (Capitalisation) table is a table providing an analysis of a company’s percentages of ownership, equity dilution, and value of equity in each round of investment. On Runway Pro, we provide an in-depth course on how to properly fill in your CAP Table, along with a CAP Table excel template.

Raising investment, especially for the first time, is an exciting process and your first instinct may be to seek to get as much of it as you possibly can. Be careful of wanting to have your cake and eat it though, raising more money means giving away more of your company so you need to make sure you have done all your research and know exactly what to expect before you commit to anything.

By making the right decisions, you can ensure that you raise the money that you need to grow your business, without excessively diluting the ownership.