How Does Dilution Work In Startups?

How does dilution work in startups?

Dilution can be one of the most overlooked aspects of the startup journey. Especially in the early stages of fundraising.

Yet, it can also be one of the most impactful factors for startups, their founders, and everyone they touch later on.

So, how does dilution work in startups? What are the real pros and cons of allowing dilution?

How should you be thinking about it when you are fundraising?

What smart alternatives can there be for fueling your venture with all of the resources it needs, without diluting your company?

What Is Dilution In Startups?

The concept of dilution is quite simple. It refers to the strength or concentration of your ownership in the company.

Specifically, the value or the percentage of the company your shares of ownership represent can become diluted when you issue more of them.

For example, if you began with 100 shares of your company, which you all personally held as the founding CEO, you have 100% of the company.

Now, if you issue 100 more equal shares, your 100 shares have been diluted to only represent 50% of the company, and all of the rights that come with them.

The more shares that are issued, and more owners there are, the more diluted your ownership becomes.

Do not underestimate the influence of dilution in your startup. In some cases, the trade-off is more than worth it. If not essential for reaching your goals.

In other cases, the dilutionary effects of fundraising and other compensation trends can sabotage your vision and what is most important to you on this journey.

Keep in mind that in fundraising storytelling is everything. In this regard for a winning pitch deck to help you here, take a look at the template created by Silicon Valley legend, Peter Thiel (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 is being used by founders around the world to raise millions below.

How Dilution Happens In A Startup

There are a variety of ways that dilution happens in a startup.

Yet, they all really come back down to the number of shares the company has issued, who holds them, and how many owners or stockholders there are.

Common scenarios which result in dilution include the following.

Company Formation With Multiple Partners

Your original amount of stock and the value of those shares will typically mostly depend on how many founding partners there are.

If you are a solo founder you may begin with fewer shares and have 100% of the company.

Or you may form your company with four or eight other co-founders who split up the company evenly.

The more you have, the more dilution risk there is, and potentially more issues you can have later.

Or you may have silent partners who put in capital and give you full reign to run the company as you see fit.

Equity Options/Options Pools

When you are raising money for your startup, it can be common for investors to have you set aside a pool of shares for attracting employees and executive talent.

Make sure you understand the impact of this, and how it can impact funding amounts, pre and post-money valuations, and other ownership rights.

Although founders are becoming savvier and educated about more intelligent ways of structuring equity and options, it has become trendy in recent years to offer small amounts of equity to many different people in the process of building a startup.

This can include early key hires, as well as advisors and fundraising experts.

It is seen as a ‘free’ or inexpensive way to bring in the best possible talent right away, without having to give up cash.

It can have great advantages. Just be aware of the dilutive effect it can have, and the consequences of that.

2% of a brand new pre-launch, pre-revenue company may be worth nothing to you right now.

If the company is successful, that could end up being worth a couple of billion dollars. That’s the reason why you should take the time to understand how does dilution work in startups.

Selling A Part Of Your Business

Selling shares in your company can dilute your company as well, depending on how you structure it, and whether you are selling existing outstanding stock, or are issuing new stock.

Giving Up Equity In Fundraising

One of the most common and certainly most impactful situations in which dilution arises is when startups are fundraising.

When you are raising equity capital from angels, venture capital firms, and other traditional players in the startup ecosystem, it typically means you are trading a permanent stake in ownership in your company for a cash injection now.

It is not uncommon for startups to give up a 25% or larger stake in a fundraising round. Multiply that by the increasing number of funding rounds startups are utilizing these days.

The Dilution Vs. Fundraising Dilemma

While this may rarely be given the thought it deserves by first-time entrepreneurs out there fundraising for the first couple of times, it will sooner or later become a big factor to consider or deal with.

It is far better to spend a few moments understanding this concept and the pros, cons, and consequences now, than to only realize how bad the damage is from ignoring it later on.

The big debate or choice for startup founders is balancing the need and benefits of capital and bringing in outside investors versus the side effects and risks of the dilution it causes.

The more you raise often the more you’ll give up. It’s often a choice between keeping a bigger piece of a smaller pie or a smaller piece of a bigger pie.

The Pros & Cons Of Dilutive Fundraising

Capital

Gaining more cash capital now can help your startup grow faster, scale bigger, and sometimes just survive tough times.

On the flip side of this, more dilution means that when you sell your company you will get much less of the net proceeds.

In fact, it is quite possible to end up selling your company for $1B, and ending up getting zero.

Securing Important Resources

Even when they don’t need the money many very experienced and savvy entrepreneurs choose to raise equity capital.

They do it to enroll important investor advisors, attract more great talent, and open doors to all types of other resources from distribution channels to more investor introductions and enhanced credibility.

While this can be one of the cheapest ways for early-stage startups to secure these resources at the beginning, it can prove to be very expensive later.

Think about this dilution and giving up equity as deferred interest. You are going to pay for it sooner or later.

Though it may be worth doing the actual math and running a financial model to see what it will really cost versus the alternatives.

Control & Decision Making

While fundraising can bring in fantastic advisors and board members which can deliver great value, it can, and typically will also dilute your control over the company and decision-making authority.

A lot of how this plays out may be influenced by your ability to manage your investors and board meetings, as well as how intentionally and carefully you’ve chosen your investors.

You have probably already heard the horror stories of how some founders have been booted from their own companies by their investors.

Or how they’ve been blocked from making key decisions. Keep these possibilities in mind when understanding how does dilution work in startups.

Future Trajectory

Once you take capital like this you are effectively pledging to ultimately sell your company or take it public.

If that’s what you want, then bringing in the right equity partners can certainly help and help make the most of it.

However, if there are other parts of your vision and mission that are more important, and you don’t believe are possible in someone else’s hands, then this may not be the path for you.

Often the bottom line tie-breaker here is going to come down to whether your mission is about going as big and broad as possible, or having as much control as possible, and ensuring the details match your ideals.

Before we talk about how to avoid dilution, check out this video I have put together explaining how to find investors for your startup. You’ll get some valuable tips on how to find alternatives.

Ways To Minimize & Avoid Dilution

There are alternatives.

Start With A Tight Team

Some entrepreneurs have brought together a band of as many as five or eight co-founders. That’s a lot.

It’s not only expensive and messy, but it comes with a whole lot of extra politics and working parts.

Few teams that big are going to make it together the entire journey anyway. It’s possible but rare.

There can also be more intelligent and careful ways to structure equity for early hires and even co-founders to ensure you are getting the long-term commitment and value.

Negotiate

As much as you’ll hear “oh, that’s standard.” and it might be, everything is negotiable.

You can work with the price, valuation, classes of stock, and other terms to minimize dilution.

An accomplished fundraising consultant, strong advisors, and a good legal team can make a lot of difference here. So, rope in their expertise when figuring out how does dilution work in startups.

Bootstrap For Longer

Startups bleed the most equity and suffer the most dilution when raising right at the beginning when there is more risk for investors.

By delaying taking outside capital until you have proven certain things, crossed important milestones off the list, and have de-risked it for investors, you’ll have more negotiation power.

You’ll give up less when raising later rounds. For example, you may skip a pre-seed, Seed round and just go for a big, late Series A much further on the journey than is common.

Use Other Forms Of Financing

You don’t have to sell chunks of your company to get money in the door.

You can also use non-dilutive debt financing, personal loans, business lines of credit, grants, and specific types of debt like equipment leases and mortgages.

Buy-Out Earlier Investors & Owners

You may choose to use a stock buyback to buy out early partners and investors, and re-consolidate ownership and control, and concentrate your position again.

Even if you do need to bring in more capital, it may come with much less dilution in later stages when you are already in a stronger position. Consider your options carefully when working out how does dilution work in startups.

Hire Instead Of Giving Up Equity

Hire talent as employees or independent contractors instead of giving them ownership.

This can apply to key workers and advisors as well. Consider a better salary, perks, and other types of performance-based pay instead of equity.

Summary

Dilution can rob entrepreneurs of many of the things they thought they were creating.

Though it can also be necessary, if not a great trade-off. Do the math. Check your options out.

If it is right for you, then at least negotiate and position your company to minimize dilution and maximize the value you get in exchange.

Or check out these alternatives to dilution and ask if they might at least temporarily be a better strategy.

You may find interesting as well our free library of business templates. There you will find every single template you will need when building and scaling your business completely for free. See it here.