Receiving a new investment round can be a thrilling experience for startup founders. But it often comes with a downside: share dilution.
When startups receive funding, their ownership and voting power may be diluted proportionally to the amount of funding, the number of participants, and the number of investment rounds.
But share dilution is not as intimidating as it seems.
Basics: Where do shares come from?
Imagine two business partners who have a business idea — an edtech startup. They start a company and agree that it would have 1,000 shares. Each founder receives an equal 50% ownership stake.
Then, they decide that they need to attract money to begin developing their product. They raise $100,000 in a pre-seed round, giving the VC that backed them a stake in the startup.
The founders issue additional shares to give them to the VC. The number of shares issued is determined by the agreed price per share and the amount of money invested. Let's assume, just as an example, that they issued 500 additional shares. As a result, their ownership percentage has decreased from 100% to 66%, because now they own 1,000 shares out of new total of 1,500 shares.
The more money the founders raise, the more their ownership stake dilutes. Ideally, founders should aim for a dilution of 15-20% per funding round and strive to retain 50-60% ownership in the company by the time they close a Series A round. Otherwise, founders risk losing control over their startup and have a lot of questions about the dilution from VCs during the fundraising.
By diluting their shares, the founders can acquire the funding required to take their business to the next level. As the company grows and increases in value, so will the price of their shares. At the later stages, 50% of the company will obviously cost more than 100% in a just-founded startup.
Be mindful of the amount of equity given up
One of the biggest mistakes that can harm an early-stage startup is believing that a larger initial investment is always better. However, at this stage, the cost of each share is usually quite low. It's important not to ask for more money than necessary.
At the same time, the amount of money raised should be sufficient to bring the company to the next level. If founders raise less than what’s needed, they may have to seek additional funding sooner. This can result in a higher dilution than anticipated.
To predict and plan the appropriate funding sum, it’s enough to answer two questions:
How much capital do you really need for 12-18 months?
Will this amount help your startup hit the milestones required to raise a seed round later on?
Early-stage startups should not spend too much time on determining their valuation. The process of calculating the optimal company valuation using financial metrics is relatively straightforward. However, in the case of an early-stage startup, the product may still be at the prototype stage and generating little or no revenue.
At this stage, investors typically evaluate a startup based on the amount of funding requested. For instance, if you request $1 million and offer 25% ownership in the company, your startup would be valued at $4 million.
In each subsequent funding round, the founders are likely to give up approximately 20% of their ownership in the company. Therefore, requesting a large amount of money in the initial funding round can result in the founders becoming minority shareholders too early. This can mean that they lose control over the decision-making at the company.
It is important for founders to frequently review their startup's cap table to gain insight into the ownership structure and monitor the level of dilution. By doing so, they can make sure they maintain a significant stake in the company after their next round.