How Much Dilution Should Founders Factor In For Financing Rounds?
Executive Summary
- Startups raise money in stages to fund growth
- Fundraising options are either dilutive (equity) or non-dilutive (grants, microloans)
- The five stages outlined below are a guide to get founders started for dilutive funding (1. Pre-seed, 2. Seed, 3. Series A, 4. Series B, 5. +Series C)
Introduction
Startups go through a variety of fundraising rounds throughout their lifetime. Despite the difficult macro-environment, a ton of venture capital funding is sitting on the sideline, waiting to be deployed. However, companies can also bootstrap their way to success and growth in addition to securing venture capital and other alternative financing services such as crowdfunding, investment syndicates, etc. A plethora of new venture firms also bring different approaches and promises of value add to the market.
With this post, we provide insights into the topic that is not often discussed with founding teams but is an important metric to consider to ensure future fundraising success. Several VCs will not invest in companies when founders and employees have been diluted well below established benchmarks. There are always exceptions, but founders should remember their capitalization table, which shows the number of shares and the ownership percentage of all shareholders in a company.
1. Pre-Seed Capital
You have an idea, two to five team members, and preferably an early working prototype at this stage. Most repeat founders will be able to secure funding without a working prototype and with just an idea. Funding at this stage covers the very early stages in the life of a startup and is often comprised of three main sources of financing:
- Friends and Family (FF Round)
- Business Angels (BA)
- Accelerators (aka company builders like YC, Techstars, and Rockstart)
The round size will vary between €50K and €500K, and valuations are capped at ±EUR3mm, usually in the form of a convertible note or SAFE (a simple agreement for future equity). The investors will look to get a ±15% ownership stake, with many accelerators asking between 5 to 10% of the company and the balance between FF and BA.
2. Seed Round (Pace Relevant)
Seed funding, also known as seed money or seed capital, is necessary to start a company; funds usually go toward customer/market research and product development. A seed round refers to a series of investments in which various investors (typically no more than ten but preferably no more than 5) participate to provide funding in exchange for convertible notes, preferred stock options, or seed round equity.
There are geographical differences to consider, with the USA having higher valuations and corresponding round sizes.
Europe: In Europe, the typical seed round will be between €500K to €2.0 million, and the median pre-money valuations range between €4 and €8 million, depending on the sector.
USA: The typical seed round will be between $500K and $3.0 million in the USA, and the median pre-money valuations range between $10 and $12 million, depending on the sector.
At Pace, for this stage, we look for a founding team of at least two members, up to 8 additional team members, an early version of a product/service, and some user feedback or one or two signed commercial agreements. After the conclusion of this round, the cap table will generally look as follow:
- A VC firm will look to have a 10%-20%
- A group of angel investors/pre-seed will look to get 5–10%.
Often, the seed and angel rounds happen simultaneously, so another way to view this would be to have all the investors with ±30% of the fully-diluted cap table.
3. Series A Round (Pace Relevant)
The best-performing European seed stage funds will have around 40% of their portfolio companies manage to secure a Series A round. Startups that get to this stage have usually figured out early versions of their product/service and the market size and needed capital to scale (hire people and improve distribution systems).
Series A rounds (and all subsequent rounds) are usually led by one investor, who anchors the round. Getting that first investor is essential, as founders often find that other investors fall into line very quickly once the first one has committed.
Europe: Typical European Series A rounds range from €4 to €6 million. The median pre-money valuations range between €15 and €22 million, depending on the sector. Although it might seem that Series A deals in Europe are abundant, it’s worth mentioning that less than 20% of European companies have managed to secure an A round since 2015.
USA: From November and December 2021 to January and February 2022, Series A rounds posted the most significant average decline in round size in the United States. Still, Series A rounds on both a median and average basis in 2022 remain around the $10 to $12 million mark, significantly higher than European counterparts. The median pre-money valuations range between $40 and $60 million, depending on the sector.
Regardless of geography, Series A rounds are led by traditional Venture Capital firms that like to own between 15 and 25% of the startups. Therefore, upon completing this round, startups should aim that all external investors have no more than 50% of the fully-diluted cap table. Said another way, founders and ESOP combined should be close to or higher than 50%.
4. Series B
Series B’s are all about scaling. Successful startups at this stage tend to have an established and growing user base and a working business model.
Europe: Series B rounds in Europe usually start at €7 million and can be as high as €15 million. Europe invested $5 billion in Series B deals in 2017 compared to $14 billion in 2021.
USA: As per Carta, Series B rounds in the USA usually start at $25 million and can be as high as $50 million. In 2017, the US invested $16 billion in Series B deals compared to $55.9 billion in 2021.
Additionally, as highlighted on Crunchbase, median round sizes of Series B deals in Europe remained below Series B deals in the US from 2017 to 2021. In Europe, median Series B round sizes grew by 76% between 2017 and 2021; in the US by 89%.
In other words, Series B deals are less common in Europe than in the US and tend to be led or include the participation of US-based VC firms.
Series B venture capital firms like to own between 10 and 20% of the startups.
5. Series C and the following rounds
When companies reach this stage, they are considered to be fully mature. This means they are ready to expand to new markets, acquire other businesses, or develop a new line of products. Therefore, the business model is working -whether or not the company is profitable.
In the past, it has been common that a Series C round is a final push to prepare a company for an IPO or an acquisition. In Europe and the US, financing rounds at these stages range from tens to hundreds of millions. In the last 24 months, private equity firms and investment banks have gotten involved. They have started to lead deals with the participation of large Venture Capital firms as companies have stayed private longer, so it is common to see Series D and E rounds lately.
Venture capital firms like to require ownership stakes between 10 and 15% of the startups at this stage.
Conclusion
We hope this provided enough clarity when it comes to how much equity should be given away in each round, and where that equity will be dispersed.
Before founders start on their funding endeavors, make sure you know your company’s valuation and what kind of investor your startup funding will likely come from. It is important to be prepared.
