From Founder to Minority: Equity Dilution Mistakes To Watch Out For

Equity dilution mistakes can eventually result in the founder being left with a minority stake in the company they built. Don’t let this critical pitfall take away from your control over the company’s decision-making and ownership. Or, the profits and returns that are rightfully yours.

Raising funding is a crucial aspect of entrepreneurship. Many top founders have undoubtedly built companies through bootstrapping and rolling revenues back into operations. But most startups can get only so far on the founder’s personal funds and capital raised from friends and family.

At some point, you’ll need to approach external investors. But, as your expert fundraising consultant will advise, you should tread cautiously when getting capital.

Bringing in investors invariably involves dilution or sharing the company’s ownership. They may also require a board seat and/or a say in its operations and decision-making.

On the flip side, not raising capital could result in the startup running out of money and stalling. The key is to create an optimum balance between backing the company with a cash infusion and securing ownership. Keep in mind that each time you accept investor money, you risk dilution.

Impact of Dilution Through Funding Rounds

With each successive funding round, you’ll give up more equity. What seems like a small percentage today can quickly add up dramatically over time until the finish line. That line being when you exit the company successfully, either through selling the company or an initial public offering (IPO).

Statistics indicate that an incredible 70 % of startups fail with investors and founders getting nothing in return. By the time founders move from their seed round to the Series A, they lose an average of 28 % of equity. If you were to examine the dilution per round, here’s what the numbers say:

• Seed round – around 10% to 20%
• Series A round – around 20%
• Series B round – around 15% to 20%
• Series C round – around 10% to 15%

Aside from ownership and control issues, you should also be mindful of the percentage of profits you’ll claim. Dilution typically results in broader profit distribution, leaving behind fewer returns for the owner/founder. Don’t overlook the possibility of lower share prices either.

Moreover, excessive dilution on your cap table could make it harder to raise capital. This is why you should be wary of the pitfalls that drain ownership quickly. Here are some of the most common equity dilution mistakes founders make. And what you can do to avoid them.

Equity Dilution Mistakes Founders Typically Make – Raising Funding Too Early

Founders often make the mistake of raising too much money too soon. Remember that dilution is directly proportional to the risk investors take. This is why lead investors may require a bigger chunk of equity since their risk is much higher.

This factor holds true even if you’re using instruments like convertible notes and SAFEs or simple agreements for future equity. For this reason, it’s advisable to estimate the capital you’ll need for the startup to reach its subsequent goals. Accurately predicting is challenging, but a rough idea works.

Raise only the amount you absolutely need to achieve its milestones for the next growth stage. If you can demonstrate success, investors are more likely to offer capital confidently. Investors appreciate it when founders run lean operations and utilize the available capital efficiently.

These strategies indicate strong and competent leadership, which is worth supporting with additional funding. At the same time, never lose sight of the fact that every dollar buys investors a larger ownership stake.

Misunderstanding How SAFEs Work

When investors offer capital through simple agreements for future equity (SAFEs), they expect future stock in the company. You’ll accept capital on the condition that they can claim equity at a later date, at a valuation cap. Or a discount rate for investors.

This means that you’re only deferring dilution, which can cost you 20% to 30% more equity later. As long as your startup is in its early stages, SAFEs and convertible notes may seem convenient options. However, understand the terms and their long-term impact on dilution before accepting.

The biggest error founders make is not realizing that the ownership percentages aren’t calculated until the company’s valuation is determined. Typically, this valuation is done when you’re ready to raise a seed or Series A round. The type of SAFE and its terms influence the stock dilution.

SAFEs can be pre-money and post-money, and not calculating their impact is another of the equity dilution mistakes you’ll make.

Pre-Money and Post-Money SAFEs

• Pre-money SAFEs are typically less dilutive for the founders since each investor’s ownership is calculated at the same time — that is, when you raise the next funding round.
• Post-money SAFEs enable investors to preset an ownership stake in the company that they can claim. This percentage remains constant regardless of the additional investors backing the company in subsequent funding rounds. On the face of it, you might prefer this approach since you know precisely how dilution will play out. At the same time, be wary because these SAFEs only dilute the founder’s ownership stake. The investors’ stake remains intact, and you could be at a distinct disadvantage.

Knowing how to value your company is an essential skill for an entrepreneur. You’ll know how to calculate the potential dilution before raising capital. Check out this video in which I have explained in detail how to do that.

Valuation Cap

Investors may require a valuation cap as part of the SAFEs’ terms and conditions. This cap is the maximum company valuation at which their invested capital converts into shares. It enables investors to receive not only more shares for their early investment but also at a lower price per share.

Let’s assume the company’s valuation is higher during the seed round than the SAFE valuation cap. In that case, you’ll issue a high number of shares to the investors, which can significantly dilute your ownership stake.

Here’s an example. You raise $500K via SAFEs at a valuation cap of $5M. Next, you progress to the seed stage round, where you raise funding at a $10M pre-money valuation. If there is no valuation cap, investors’ $500K converts at $10M.

However, thanks to the valuation cap, investors can convert the SAFEs worth $500K at $5M. Here’s how that impacts the pricing of the shares.

• At $10M valuation, the price per share = $10,000,000 ÷ 10,000,000 shares = $1.00/share
• At the $5M cap, the price per share = $5,000,000 ÷ 10,000,000 shares = $0.50/share

This clearly indicates that investors can convert their SAFEs into shares at a price that is 50% of the market value. Accordingly, they get

• $500,000 ÷ $0.50 = 1,000,000 shares (with cap)
• $500,000 ÷ $1.00 = 500,000 shares (without cap)

This is why accepting a valuation cap can be one of the critical equity dilution mistakes founders may make. The example clearly indicates that investors could claim twice the number of shares for their invested capital. And that results in your ownership stake depleting.

Conversion Discount

Instead of a cap on the valuation, investors may require a conversion discount as a condition for offering capital. Accordingly, you’ll offer to convert their SAFEs into shares at a discounted rate from the market share price. Let’s try an example.

You’re raising a Series A funding round in which the price per share is $1. Depending on the terms of the SAFEs, investors holding them can claim shares for 75 cents or 80 cents. Alternatively, investors demand both–a valuation cap and a conversion discount.

During a subsequent funding round, they simply choose the option that will yield them a lower price per share. Or, a higher number of shares. Be sure that you know exactly what you’re getting into before agreeing to these terms. It’s one of the critical equity dilution mistakes that impact your stake.

Maintaining SAFEs for Too Long

Keep in mind that SAFEs should be used only to raise capital in the initial stages. Particularly when you’re raising only small sums, like from friends and family, at the pre-seed stage. It’s advisable to convert them into shares quickly, preferably as soon as you raise a qualified round.

If the number of SAFEs is limited, you’ll have a clean, simple cap table that clearly specifies the ownership percentage. The founders and investors understand precisely what their stake is after the conversion. If you need more capital, raise a formal round instead of issuing more SAFEs.

Don’t overlook the fact that SAFEs don’t appear immediately as equity. Another of the crucial equity dilution mistakes founders make is to underestimate the equity they’ve given away. The cap table may look clean, and you might think you own an 80% stake. Instead, it could be 55% or 60%.

Post-conversion, the actual stake could come as a rude shock. Different SAFEs may have varying valuation caps and conversion rates, resulting in complete chaos when they convert at once. Aside from dilution, you could be looking at complicated pro-rata rights that take away company control.

SAFEs can also complicate your fundraising efforts, since potential investors are wary of an unclear cap table. The lack of financial discipline could come across as a red flag.

Keep in mind that storytelling is everything in fundraising. In this regard, for a winning pitch deck to help you here, take a look at the template created by Peter Thiel, Silicon Valley legend (see it here) that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.

Remember to unlock the pitch deck template that founders worldwide are using to raise millions below.

Overlooking Vesting Schedules for the Co-founders and Team

Vesting schedules determine the time frame according to which the founders and team members accrue equity in the company. This strategy ensures that they earn equity over time instead of owning it upfront. Vesting is a critical anti-dilution safeguard, particularly if there are cofounders involved.

A cofounder could exit the company and take with them a significant chunk of the ownership. They could continue to exercise control over its operations without contributing any value. The remaining founders may find that their stake is diluting quickly with each new funding round.

Over the long term, this issue can impact decision-making and control of the company. The existing owners may lose the motivation to work for its interests. Particularly when their share in the profits begins to deplete quickly.

This issue can impact your fundraising efforts or a potential merger and acquisition (M&A) deal. Potential investors are wary of backing companies where founders fully own their shares without a vesting schedule. Almost 70% will walk away viewing the lack of alignment as a red flag.

This is why you should incorporate a vesting schedule in the cap table. For instance, 4 years of vesting with a 1-year cliff period. This strategy will help you avoid another of the crucial equity dilution mistakes that newbie founders typically make.

Issuing Side Letters

Founders often sign side letters as part of their investment agreement with investors. These letters are separate documents and assign investors special rights that others don’t have. For instance, the right to receive better terms than future investors who participate in further funding rounds.

These terms can include a better valuation cap or a higher conversion rate. Or pro-rata rights that enable investors to purchase additional shares in future rounds so they can maintain their ownership stake. These side letters can confer broader pro-rata rights retroactively to their holders.

Founders should also be wary of the information rights clauses or “access to financials.” These rights enable investors to access company financials, KPIs, board materials, or investor updates.

This could place your company at a distinct strategic disadvantage, not to mention face the threat of sensitive data leaks. Future investors may hesitate to offer funding to companies that have issued aggressive side letter rights.

Offering side letters can be another of the equity dilution mistakes founders make, since they quietly shift power and influence. You risk unexpected dilution and changes in the cap table and governance structure when investors exercise their rights.

The Takeaway!!

Funding is the lifeblood of a company, and you can’t expect to scale without raising capital from external sources. The key is to be extremely wary about the terms and conditions you agree to. Always be mindful of the potential dilution in your ownership stake.

Being strategic about your fundraising approaches is always advisable, which is why it’s advisable to have experts at the table. Retain the services of highly experienced consultants who can point you in the right direction. They’ll help secure your company from these equity dilution mistakes.

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