Neil Patel

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How to think about startup dilution? In other words, how should startup entrepreneurs think about dilution?

Dilution is a factor that is often overlooked by new entrepreneurs. Yet, it can have an immense impact on the journey, and certainly the ultimate outcome and exit.

It is a component of startup fundraising that can help fast-track everything and create supersized companies. Though this can also turn an inspiring opportunity into a miserable marathon, with zero dollars for the founders at the end.

It is important for entrepreneurs to understand dilution before they even start. As well as to decide which philosophy they will embrace before they start fundraising. Then to wisely approach funding their ventures with the mission and big vision in mind.

Here’s what you need to know when you’re ready to think about startup dilution, its advantages and disadvantages, perks and pitfalls, how other experienced founders view it, and how to minimize any negatives.

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    What Is Dilution In Startups?

    Dilution in startups refers to the watering down of shares and stock in the company.

    The more stock is diluted, the less ownership the original stakeholders have in the company. Which also waters down how much control and voting rights they have in their own startup. As well as reducing what their stock is worth, and how much they may receive when the company goes through a liquidity event. Such as being acquired.

    Startup Fundraising 101

    Although there are many ways to get money to launch and fuel a startup, equity fundraising has become synonymous with ‘getting funded’.

    This money from angel investors, startup accelerators, venture capitalists, private equity firms, and others, traditionally means exchanging shares in your company (equity ownership) for their cash injection.

    As this happens, the original owners’ share of the company continues to be shrunk, and ‘diluted’.

    You may have seen early angel investment rounds where investors want 25% to 50% of the company in exchange for their investment. The stakes given up in later rounds will typically be smaller but account for a lot more money.

    There may also be pools of stocks set aside for employee stock options, and giving equity to important hires or advisors along the way.

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    Many things are affected in this dilution process, including voting rights, board positions, decision-making authority, the value of stocks, and who gets paid what, in what order when a liquidation event happens. Including M&A deals, future funding rounds, going public, filing for bankruptcy, or closing down the business.

    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.

    The Pros & Cons Of Equity Fundraising

    For everything in life and business, there are always trade-offs between potential perks and pitfalls, advantages and disadvantages.

    That certainly remains true with fundraising for startups and accepting outside investment. Here is what every entrepreneur needs to know before going out fundraising, or even building it into their initial business plan. Read this information and understand it before you think about startup dilution.

    The Pros Of Equity Fundraising

    More Capital

    The largest amounts of startup funding typically come in the form of acquiring equity in the business. Although some will also take on large amounts of debt financing or credit lines, the big money is often coming from equity investors. So, if you are dreaming of building a billion or trillion-dollar company, this is where the money is at.

    Avoiding Debt

    Debt financing does have its place in many startups. Though debt can be dangerous. Especially for early-stage startups.

    Equity is designed to avoid the burden and stress of regular repayments, static overhead, and loan maturity dates, which can all break a company before it really gets a chance to succeed.

    More Slack To Get It Right

    While the opposite can certainly be true of equity fundraising as well, more capital, from the right investors, can give your venture the time and financial flexibility it needs to make good decisions, build a better product, serve those your company touches better, and buy up market share.

    A lack of sufficient capital otherwise often forces entrepreneurs to make self-sabotaging short-term focused decisions. Which eventually kills them off.

    Bringing In Expertise & Connections

    One of the main reasons that repeat entrepreneurs raise equity capital is not money at all. Often they could fund their new ventures with the capital they received from previous exits.

    Yet, they have found an appreciation for the expertise, credibility, speed, and scale that comes from bringing in the right equity partners.

    In some cases, this is absolutely vital for the venture to be viable. For the rest, it definitely provides a huge advantage over competitors and can make the journey faster, easier, and more enjoyable.

    Creating A Much Bigger Pie

    Theoretically, the more capital you bring in, the larger the value of your company. If you want a company that is worth billions, then this is the way to go.

    You may own a smaller share of that multi-billion dollar company, but the pie to be shared is far larger than if you tried to bootstrap it the whole way.

    The Cons Of Equity Fundraising

    Control

    The most obvious negative of giving up equity for startup entrepreneurs is giving up control of their company.

    As you give away equity and board seats, you are giving away voting rights and decision-making control.

    This can range from product features to customer service, pricing, how money is spent and budgeted, electing and firing executives (including the original founders), authorizing future fundraising, debt, and the issuance of shares, as well as negotiating and accepting acquisition offers.

    Beginning A Never Ending Fundraising Cycle

    Once you take formal equity funding you are really beginning a never-ending cycle.

    Today, this frequently means a continuous cycle of raising money through Series C, D, or even later rounds. Which only really changes once you go public, or are acquired.

    With new injections of capital needed every 6 to 18 months, you will always be in fundraising mode. That means networking for your next investors, preparing fundraising materials, pitching, and negotiating term sheets. All while staying on track to hit the milestones you promised in the previous round, and maintaining a high rate of growth.

    Fundraising alone can take up 50% of your time as a founder.

    A Much Smaller Slice Of The Pie

    Without bringing in sophisticated equity capital at scale, you will almost invariably have a much smaller pie. If you do take the money, the pie can be many times larger. Yet, your piece of that pie is going to get smaller and smaller. With all of the other terms and clauses in these agreements, it is possible that entrepreneurs selling billion-dollar companies actually walk away with zero when the company is sold. Even if their investors get right.

    Even as you’re reading up about how dilution works, you’ll also need more information about how financing rounds work. Check out this video where I have explained in detail facts that you’re sure to find helpful.

    Three Ways To Think About Startup Dilution

    There are three main mindsets to choose from when it’s time to think about startup dilution.

    1. I’m Okay With A Smaller Slice Of A Much Bigger Pie

    This is an approach that many savvy entrepreneurs take. At least to an extent.

    If you can take in equity and investors, and instead of a $10M company, you can create a $10B company, and you still maintain a 10% stake and payout on the exit, the bigger pie is better, right?

    This also works if you just want the reputation of building a supersized company. Regardless of any financial benefits.

    However, you must watch the details and fine print in your funding agreements. Otherwise, you may end up with zero after all of the work and stress you put in.

    2. I Want To Maintain All Control, Even If My Pie Is Much Smaller

    Another way many new entrepreneurs think about this is that they want all the control. They have set out to do things better than any other company or answer in the marketplace, and don’t want that spoiled by the pressure, and at the dictation of other stakeholders.

    In some cases, this may be completely reasonable. Though possibly short-sighted. Again, so much depends on the investors you let in. That is up to you.

    Still, if you build a $10M company, and own 100% of it, some things will be simpler, and it’s not a terrible payday.

    However, if you turn down a $500K angel investment for 50% of your company, just because you spent two years on this, and put in $30,000, that may not be wise. Nor a path to progress. Especially if you haven’t achieved substantial traction and product market fit yet.

    3. I Will Do What Is Best For The Mission & Company

    The third way of thinking is not to focus on hoarding control, or size at all costs, but to be more ambiguous in how the journey will play out.

    After all, in reality, it is your job as a stakeholder to do what is best for the company, period.

    In some cases, it may be in the best interest of the company and your customers to protect it from poor decisions by greedy outside investors. In other cases, the best way to achieve the mission and have a positive impact on the greatest amount of people is to accept larger amounts of funding to win the space, expand fast, and build the greatest possible team and manufacturing and delivery capacity.

    It is about staying on mission, not wavering from the grand vision, but being flexible in how you get there (without sacrificing your values). In reality, this is the only way that startups survive and thrive anyway.

    How To Minimize Startup Dilution When Fundraising

    Just because you’re willing to take in a lot of investors and capital, doesn’t mean you should ignore the impact of dilution. You should still be working to minimize the risks and downside, while enjoying the upsides. So, how do you do that?

    Negotiate Better Deals

    You don’t have to just accept every term sheet you are offered as is. This is where the help of a great fundraising advisor comes in.

    They can help you negotiate each investment. Try to give up less in each round. Demand more value for your shares, board seats, and voting rights.

    Pick Your Investors Wisely

    All of this really comes down to the investors you allow into your company. Be sure they are aligned with your mission, vision, and values, and you can create a fair win-win together, and worry less about how you will get along and operate to get there.

    Start Raising Later

    Investors typically get less equity for larger dollar investments in later rounds. So, if you can bootstrap, and wait to raise after you de-risk and prove it, then you’ll suffer less dilution, and be in a better-negotiating position.

    The Alternatives: Non-Dilutive Funding Sources For Startups

    If dilution isn’t for you, or you want to minimize it, while bringing in more funds, your startup can mix up the capital stack with a variety of financing types.

    This includes:

    Summary

    Dilution can be dangerous for startups and their founders. It can also be a fantastic trade-off. It is all about understanding it, optimizing it, and picking the right investors for your venture. Make sure you understand all the aspects before you think about startup dilution.

    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.

     

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    Neil Patel

    I hope you enjoy reading this blog post.

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