As a startup founder, looking ahead toward company value growth is exciting. At the same time, considering how significant capital investments into your early-stage business might affect your ownership may not even cross your mind.
Dilution is far from the most attractive aspect of being the owner of a growing startup. However, it is critical that founders understand how dilution shapes startup ownership throughout the life of the company. Dilution is not inherently negative. Owning a smaller slice of a higher-valued pie can bring far greater revenue over time.
In this blog, we’ll dive into what founders need to know about valuation and dilution, how these affect ownership, and key points to protect that ownership along your business journey.
Startups Need Strong Foundations
Strong foundations help determine the startup structure for years to come.
First, ensure the founding team’s shares are on an agreed-upon vesting schedule. Investors are likely to require a vesting schedule be in place, and it’s better for the founders to have it set according to their terms rather than an investor suggesting their own terms down the road.
Second, create a cap table, and keep it clean. This document outlines the equity structure of the startup, and serves as a roadmap for future growth. Forecasting growth changes and outlining those predictions in the cap table can guide founders through investor negotiations later on.
How is Startup Valuation Calculated?
Valuation determines the dollar value of the startup. There is one key split: pre-money valuation and post-money valuation.
Pre-money is what investors believe to be the value of the startup before any investments are made.
Post-money is that estimate plus the amount of capital invested.
If a startup intends to raise money with certain instruments like SAFEs, founders must understand the difference between pre-money and post-money valuations. The structure used can generate different ownership percentages, which can be critical to safeguarding ownership during future fundraising rounds.
What is Dilution?
Dilution refers to the lack of ownership a founder trades in exchange for investor funding. As soon as a startup accepts an investment, the founders’ ownership shrinks. As more money is raised, a founder’s ownership decreases proportionally. This mechanism is called dilution.
If the post-money valuation of a company is $10 million but $2 million of that value came from an investment, the contributing investor essentially owns 20% of the company. The founders own a smaller slice of the business, but the size of the pie has grown.
Do I Have to Shuffle my Option Pool?
During fundraising rounds, most investors will insist on increasing their employee stock option pool. While 10-20% of startup stock is typically set aside for future hiring and talent retention incentives, investors usually prefer founders to increase the option pool before financing rounds close.
As valuations are calculated on a per-share basis, shuffling the option pool before valuation means value dilution affects the founders rather than the investors. Investors will also want to see board approval, and the restructuring properly documented ahead of any capital transfers.
How Does Dilution Compound Across Funding Rounds?
Dilution benchmarks vary by fundraising stages. These benchmarks also shift over time. Percentage rates combined with board seats are often considered appropriate, and it’s important to understand the expectation and the benchmarks before negotiations begin. We’ll take a look at some recent benchmarks for each stage, but remember, it’s always important to speak with an experienced startup attorney who can advise you on appropriate expectations.
Seed
Dilution often ranges from 18-20%. In sectors with very high demand, startups may be able to demand premium valuations which could result in less dilution. Investor board participation is rare at this stage.
Series A
Investor negotiations often include one board seat during the Series A funding round. This is typically reserved for the largest check writer. Dilution percentages fall within a wider range – somewhere between 15-20% – depending on the sector and demand.
Series B
In this round, percentages and board leadership become more variable and less predictable. Sometimes founders maintain majority control, other times investors take the lead. Dilution percentages can range from 10-20%, but there are many more variables that determine valuations at this stage.
Series C+
At this stage, after valuations are set and funding has closed, founders usually retain somewhere around 35-45% company ownership. While this number may look small compared to owning 100% of the company at the earliest phase, startup valuation should look proportionally larger at each stage. Ultimately, that is the goal from formation to exit.
Series Growth Exceptions
When a startup company is distressed or struggling, founders will not be surprised at lower valuations as they seek funding. Investors may still be interested in company participation. Nonetheless, they may negotiate for more board seats and more control in exchange for their capital infusion.
What Investor Protection Mechanisms Should Founders Understand?
Multiple mechanisms are included during capital infusion agreements to protect investors. Founders must understand the logistics and conditions of each to help minimize ownership erosion and protect control of the startup.
Pro-Rata Rights
Pro-rata rights gives investors the option to purchase future shares in order to maintain their relative ownership percentage. If early investors exercise these rights, they absorb some founder dilution, but there may be less equity available for future participants.
Right of First Refusal
The right of first refusal (ROFR) ensures existing investors maintain the right to purchase shares being sold by a shareholder before outside buyers. This prevents unnecessary outside participation or further diluted ownership.
Pay-to-Play Provisions
Pay-to-play provisions help guarantee cash flow during crunch times, and ensure investors maintain preferred privileges. These provisions also protect the startup by incentivizing early investors to continue investments or risk losing privileges.
HJF Law Helps Startups Optimize Valuation and Dilution
As your startup grows, accepting venture capital to increase company valuation is compelling. This is one reason why it’s never too early to hire a lawyer!
Expert startup attorneys like the members of the HJF Law team can ensure your startup’s cap tables, term sheets, and other paperwork is clean and complete from the get-go. Establishing a solid foundation helps set up your startup for success. Optimizing negotiations during funding rounds can further that success potential, and those are critical phases to have an attorney at your side.
No matter what stage your startup is in, careful planning and attention to detail is key in all investor negotiations. Learn more about HJF Law’s startup advisory services at hjflaw.com. Call us at (917) 726-8184 for a free consultation to see if we are the right fit for your company.