Equity dilution is an important concept for pre-seed startups, more so as they seek early-stage funding. In general, issuing new shares to raise money may alter the percentage of ownership held by current shareholders in a startup.
For instance, if a startup with 1 million shares issues 500,000 more, existing shareholders will see their ownership reduced by one-third. Understanding how it works and its effects will help founders, investors, and employees make better decisions about ownership and investments.
This guide will walk through the basics of equity dilution, how it impacts startups, and ways to manage and minimise its effects.
Equity dilution at pre-seed stage happens when a company issues new shares, reducing the ownership percentage of existing shareholders. Although the number of shares a person owns might stay the same, their share of the total ownership becomes smaller.
It occurs when a company creates and sells additional shares to raise money. For example, if a company with 1,000 shares issues 500 more, the total number of shares becomes 1,500. This reduces the ownership percentage of the original shareholders.
Equity dilution at pre-seed stage startups can have a significant impact. When new shares are issued, the ownership percentage of founders and early investors decreases. This means that founders might have less control over the company and a smaller financial stake, which can affect their motivation and sense of value.
Early investors also face a reduced share of future profits and potential returns. While dilution is often necessary to raise capital and support growth, it’s important for startups to manage it carefully to ensure that founders and investors retain meaningful ownership and control.
Pre-money valuation is the value of a company before it receives a new investment. It reflects the company’s worth based on its current assets and performance. For example, if a company is valued at $5 million before a funding round, that’s its pre-money valuation.
Post-money valuation, on the other hand, is the company’s value right after receiving a new investment. It includes the new capital injected during the funding round. So, if the company gets $1 million in funding, the post-money valuation would be $6 million ($5 million pre-money valuation plus $1 million new investment).
These valuations help investors and founders understand how new investments affect the company’s value and ownership distribution.
A captable, or capitalization table, is a document that shows the ownership structure of a company. It lists who owns how much of the company’s equity, including common shares, preferred shares, options, and any convertible securities.
In funding rounds, negotiate terms that reduce dilution. You can further negotiate an even better price by having a high pre-money valuation, hence cutting the percentage of equity you give away in exchange. Consider structuring the investment to be in tandem with the growth of your company and its milestones. Of course, the most useful tools are convertible notes and SAFEs, since they typically defer equity conversion to a later round when you will potentially attain a higher valuation and, therefore, cause less dilution.
Instead of raising a huge amount at one go, it can make sense to break funding into smaller rounds/tranches, which are linked to attainment of certain milestones or performance targets. It does help reduce immediate dilution in that new shares will only be issued once the company reaches certain objectives and higher values. This approach also causes alignment of the investors’ interests with progress and growth.
A good, detailed long-term plan should project growth, funding needs, and equity compensation. It will help in the management of equity distribution and lessen its impact when future capital requirements and compensation strategies are forecasted in advance. Be sure equity compensation is based on company performance and growth and that it balances the motivational needs of employees against the preservation of ownership for founders and early investors.
To communicate the impact of equity dilution to stakeholders, be clear and open about why dilution is happening.
Explain that new funding or issuing more shares helps the company grow and increase its value in the long run.
Show how this affects ownership percentages and share values using simple charts or cap tables.
Highlight the benefits, such as more capital for growth, and reassure stakeholders that their interests are being taken into account.
Clear and honest communication helps maintain trust and ensures everyone understands the reasons behind the changes.
Convertible notes and SAFEs (Simple Agreements for Future Equity) are tools early stage startups use to raise first funding round while minimizing immediate equity dilution.
Convertible Notes: These are short-term loans that convert into company shares later on. They usually come with benefits like a discount or valuation cap, which means early investors get a better price per share when the note converts. Since the conversion happens in the future, it helps avoid immediate dilution for founders and early investors.
SAFEs: SAFEs are agreements that give investors the right to receive shares in the future, often during a later funding round. They often include terms like a valuation cap or discount, giving early investors better deals compared to future ones. SAFEs delay the equity issuance, which helps reduce immediate dilution.
Both convertible notes and SAFEs allow equity dilution in startups to raise money now without immediately affecting ownership, making them useful for managing and delaying dilution while securing needed funds.
Splitting equity among co-founders is a crucial decision for your startup. Here’s how to approach it:
First, evaluate what each co-founder equity split brings to the table. Consider the time, money, and resources each has invested. Assess the value of each person’s skills, experience, and network. Those with more significant contributions might deserve a larger share of the equity.
Next, define roles and responsibilities clearly. Decide who will handle product development, marketing, sales, and operations. This clarity helps in determining a fair split. Also, consider each founder’s future commitment. Discuss whether they will work full-time or part-time and their long-term involvement.
Using a vesting schedule is essential. This means founders earn their equity over time, protecting the company if someone leaves early. Ensure all discussions are transparent and aim for a split that everyone feels is fair.
Draft a formal agreement outlining the equity split and terms. Consulting a lawyer can make sure everything is legally binding and clear. Seek advice from mentors or experienced entrepreneurs. Equity calculators and online frameworks can also be helpful.
Be prepared to revisit and adjust the equity split as the company grows. Changes might be necessary as new information and circumstances arise.
Equities dilution is what every pre-seed startup aiming to raise early-stage funding needs to understand. It impacts the percentage ownership for founders, investors, and employees and hence affects their share percentage and potential return. Knowing how dilution works will help any early stage startup make better decisions about raising money and managing ownership.
By negotiating the most favourable possible deal structure, utilising convertible notes or SAFEs, and planning equity compensation wisely, a startup can manage and minimise dilution. It will be able to raise the capital it needs and at the same time make sure that its ownership is well balanced and fair. Equity dilution awareness helps a startup grow without losing its most important values in the process for all stakeholders.
