This is part five of my big ol’ nine-part series, exploring every imaginable aspect of startup funding. From funding rounds to valuation methodologies, get ready for a complete crash-course in funding.
Most founders start out owning their company.
But to grow as quickly as possible, you’ll need investment, and to secure the capital you’ll need, your investors will want to own a part of your company.
The faster you grow, the greater your burn rate becomes, and the more capital you’ll need. You move from pre-Seed to Seed to Series A, but with every cash injection you’re forced to give up another slice of your company. Offer too little, and the investment dries up — offer too much, and you’ll soon find yourself without a share in your own company.
THE PROBLEM OF DILUTION
Company ownership is determined by shares. In the early days, it’s likely you (and your co-founders) will own 100% of your startup’s shares:
But in order to give equity to investors, your startup needs to issue new shares. If an angel invested an amount equal to 20% of the value of the company, you’d need to issue shares to reflect his ownership stake: in this case, an additional 25 shares.
You still own your original 100 shares, but now, the company’s ownership looks like this:
Jump ahead to the next funding round. This time, a VC invests an amount equal to half the value of the company.
Assuming equal dilution (which might not always be the case), you’ll need to issue 125 shares to reflect the VC’s ownership stake.
As a result of just two rounds of investment, you’ve gone from owning 100% of your company, to 80%, to just 40%. If you aren’t careful, subsequent rounds of investment can leave you so diluted that you’ll lose control of board seats, and even the company’s direction.
This apparent horror story leads many founders to take staunch anti-dilution measures. But dilution serves a purpose: to attract skilled people and resources to your startup.
Whether it’s incentivising a respected VC with a sizeable ownership stake, or luring top talent with an options pool, offering equity is beneficial to your startup, and attempting to hold on to as much equity as possible could limit your growth. Taken to an extreme, anti-dilution practices could leave you as the majority shareholder of a worthless company.
A balance needs to be struck, between incentives and control, investment and ownership: but how do we find that balance?
PRE-MONEY AND POST-MONEY VALUATION
Let’s assume both you and your investor have valued your early-stage startup at $100,000. Your investor is willing to contribute $25,000 to fund the growth of your company. How much equity should they get?
This depends on the nature of that $100,000 valuation. If the angel’s $25,000 investment is included in the valuation (known as a post-money valuation), they’ll own 25% of the company, reducing your share to 75%:
If that $100,000 is a pre-money valuation, the company is valued at $100,000 before the investment. That means that the angel’s investment actually serves to increase the value of the company to $125,000, reducing their share to 20% and increasing yours to 80%:
In both instances you’ve gained the capital you need to grow, as well as the expertise of a seasoned angel; the only difference is how their investment has affected your ownership. In the first example you’ve lost 25% ownership and $25,000 in valuation; in the second example you’ve lost 20%, and maintained the valuation.
EQUITY AND VALUATION
Jump ahead to the next investment round. This time, promising growth has your company valued at $1 million. Given your current equity split, the value of your ownership stake looks like this:
You’re talking to a VC who’s looking to invest $500,000, for a post-money valuation of $1.5 million. That gives the VC a one-third share in your company, diluting both your shares and the angel’s shares proportionately:
But valuations try to account for future value. If your startup is doing particularly well, you may end-up in a bidding war, so what happens if a VC thinks your company is actually worth $2 million?
After all, the only real valuation of a company is whatever someone is willing to pay for it, and a VC will pay huge amounts if they think you’ll be worth a whole lot more in the future.
Let’s work through the same example with a $2 million pre-money valuation. In light of this valuation, the value of your existing shares has doubled:
That same $500,000 investment now creates a post-money valuation of $2.5 million, reducing the VC’s share from one third of the company to one fifth.
In this instance, your equity has been diluted by 16%; but 64% of $2.5 million is larger than 80% of $1 million. Despite the dilution, the value of your share has doubled:
Better still, you’ve gained a VC, and the capital required to grow further. This is the basic premise of investment done right: even though your overall share of the company decreases, the company grows enough from the investment to increase the value of that share.
THE EQUITY EQUATION
Investment decisions can become incredibly complicated, and in the case of successful startups, minute changes to ownership stakes can equate to millions of dollars. Thankfully, there’s a simple rule of thumb we can use to work out whether or not we think an investment opportunity is worthwhile.
An investment deal is worthwhile if you believe the deal will increase the value of your shares in the long-term by more than it reduced it in the short-term. Put another way:
Though there are no hard-and-fast rules for separating out a good deal from a less-than-good deal, these heuristics can be useful for understanding what you stand to gain… and lose.
As a final word on startup equity, remember: dilution is normal. By the time they exit, successful founders often own as little as 10% of their company — and owning 10% of a billion-dollar startup is better than 100% of nothing.
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