How much dilution makes sense for a founder

Ownership is a means to retain the founders

In the startup jargon, the term “ownership” refers to the percentage of the company that belongs to its founders or any other shareholder. In this post, we will explore how much ownership founders need to maximize the potential of their ventures. We will answer the question “how much dilution makes sense for a founder of a venture-backed startup?”

Source: Index Ventures (https://www.indexventures.com/rewardingtalent)
Founders’ ownership not only matters to entrepreneurs, but it also matters to savvy investors. Why? Because it helps to align the interest of investors and founders and incentivizes founders to stay in the company throughout the whole journey.

Ownership as a mean to retain the founders

When we assess an early-stage investment opportunity, among other criteria, we analyze the “Founder/Market Fit”. We evaluate how well equipped the founding team is to capture a (new) market opportunity. The team doesn’t need to be an expert in that market, but it definitely has to be an insider of the problem it is solving.

When we invest in a startup, it’s (also) because we think that a particular founding team is the best prepared to capture the opportunity that a (new) market has to offer.

The vast majority of startups fail or are sold before reaching Series B. For those startups who succeed after reaching Series B (which are the ones making most of the returns a VC makes), retaining the best team to navigate the whole journey is key. Most of the times, that team is the founding team, especially when it is pioneering new categories, making it the most knowledgeable team in a certain field.

Savvy VCs align their incentives with those of the founders and they make sure founders have an incentive to stay in the company as long as it is needed, so they score a meaningful exit. But, how much incentive is good enough? A successful incentive means that the “Opportunity Cost” for a founder is not greater than the “Expected Value” of their equity in the company.

For example, let’s suppose a founder is leading a very successful startup and, by the time she raises a series-C round with a post-money valuation of $100m, her ownership is 2% with an annual salary of $150k. The current “Expected Value” of her equity is $2m. What if she receives an offer to join a well-established company that is willing to pay her an annual salary of $0.6m? Or what if she wants to start a new business, fully owned by her, that could be worth $20m in three years? If that is the case, her opportunity costs could be greater than the expected value of her equity.

Dilution, valuations and round sizing

If a founding team raises sizable rounds of investment, the valuation of the company has to be large as well. Otherwise, the founders will get very diluted in a short period of time.

Even if the founders manage to raise money at a strong valuation, they have to be mindful of the anti-dilution right of the VC investors (check out these examples in Spain and/or the USA). The journey is very long. A downturn, or new competitors, can hit the fundraising strategy and force a startup to raise at a lower valuation.

Source: Craft — How Much Equity Do Founders Have When Their Company IPOs?

It’s also important how efficient the founding team manages the capital raised. Interestingly, there are more and more software companies (e.g. Basecamp o Notion) that become large without the need for VC investment. Remember, the goal is not raising capital but to have millions of returning users/clients.

Understood, but how do I optimize my dilution?

In the early stages, try to raise late and little. Try to raise just the capital you need to move to the next phase at the highest valuation. Then, on a later stage, when you are ready to scale, when valuations are higher, raise as much as possible, and try to dominate the global market as fast as you can. Remember the stages of a startup.

Source: David Skok, www.forentrepreneurs.com

I know: optimizing your dilution is easier said than done. But we hope that the data we shared in this post plus our views will help you to navigate the fundraising process in a more efficient way, resulting in better and larger companies around the globe!

That’s all my friends. May the Force and the returning clients we with you!