All You Need to Know About Equity Dilution
Founders of startups face a lot of responsibilities and pressures. Besides wanting their company to succeed and cutting themselves a decent salary, founders should strive not to get fully diluted – in other words, losing control of their firm.
Nevertheless, this isn’t as easy as it sounds. Equity dilution is a powerful strategy for acquiring investment capital and attracting new investors. Hence, most entrepreneurs cannot avoid equity dilution. However, there are ways startups can limit the amount of dilution. Here is a guide on how to do it.
What is Equity Dilution?
Dilution reduces the ownership percentage of existing shareholders. Equity dilution, also called stock or share dilution, occurs when companies issue additional shares. For example, equity dilution can happen each time you publish new shares, such as raising funds or creating option pools. However, since new startups can’t afford to pay back capital directly, investors often trade funds for equity or stock in the company.
In this manner, investors come to own a part of the company and are committed to its long-term success. Founders find this both good and bad. It’s good because – the business gets the capital it needs to grow. What’s sub-optimal is having to give up too much ownership and the potential future value the business holds.
Equity dilution in practical terms and, if handled properly, is mainly harmless. However, it is an integral part of early business investment as businesses grow and need more cash to evolve. A company may do this by:
- Giving equity to employees
- Giving shareholding to new investors
- Making an initial public offering a.k.a. IPO
The Reasons for Equity Dilution
Stock dilution happens for many reasons. It includes:
Need for capital
Whenever private firms need funding, new shares are issued to investors. Again, it is to reduce the overall ownership percentage.
Growing employee pool
Most incoming investors require there to be an ESOP pool for employees. However, stock option pools get created at different times, resulting in different dilution levels for shareholders.
A pool that expands before a fundraising round dilutes only previous option holders. However, if the pool expands post fundraising round, it dilutes all shareholders, including investors.
Conversion of optionable securities
Equity options allocated to individuals, like board members or employees, can be turned into common shares, increasing the overall share count.
Offering new shares in return for purchases or services
A firm may offer new shares to the firm’s shareholders as part of the acquisition. A few times, smaller businesses offer new shares to individuals in exchange for service.
How Can You Avoid a Total Equity Dilution?
While some equity dilution is unavoidable, you should avoid being fully diluted as a startup founder. You would either lose ownership of the company or have virtually none. A total equity dilution is bad for future business and ROI. After all, it has taken you months or years to build this startup, so it would be nice to see your hard work rewarded.
To avoid full equity dilution, founders need to take several proactive steps before diluting equity. Find those right and wrong ways of equity dilution:
1. Avoid acquiring maximum investment
Everyone tries to acquire as much investment capital as possible in the entrepreneurial sphere, regardless of the risk. This is shortsighted and could lead to a complete dilution of equity. As a result, your company loses control, and you miss out on rewards later on. Instead, as a founder, you should grasp these points:
- Don’t seek out more cash than you require
- Make an accurate estimate of how much money you need to take your business to the next level.
- Don’t necessarily agree to an investor’s offer of more cash. Go back to your findings and make a decision based on them.
2. Remember your cap table
A capitalization table describes the percentage of ownership all business shareholders have. You should review this cap table regularly, at both the startup stage and as equity dilution becomes more commonplace in your business. With a cap table tool, you can project the impact of different funding options.
3. Choose investors who share a common business goal
It is a no-brainer but crucial to prevent a founder from becoming fully diluted. Prioritize investors who share your business’s goals and are trustworthy to you.
It is not easy for many startup founders. Many of them lack the capital or connections to be picky about sources of investment funding. However, avoid investments that seem unwise or money that comes from momentary investors.
On a closing note, look at what Jitendra Gupta, Founder & CEO of Jupiter, has to share about his fundraising journey. In his unparalleled transparent style, here’s what he had to say:
The changing landscape of fundraising – Today, raising money has become easier, but the pressure of performance and delivery has increased regardless of whether you are a first-time founder or have previous experience
Remember these things if you’re a first-time fundraiser:
- Don’t dilute more than 10% in your seed/angel round
- Don’t dilute more than 20-24% in Series A round
- Keep a target of retaining a minimum 40-45% stake for the founders’ group after Series C funding.
On staggering the fundraise: Raise capital when it is available but at the right dilution. Dilution should be considered in every decision, as it helps to filter out excess capital.
Advice on managing raised capital:
- The ROI will be really high if you hire a highly skilled finance professional
- Keep track of your annual expenses
To learn more about Jiten’s take on Employees and Equity Generation, chech out the full post!
Need help from our expert team about your equity dilution? Get in touch with trica equity today!