Basic Rules on Founders Dilution
Talking with a good and intelligent friend, who by the way has an impressive resume, about her seed/angel round, I asked her: How much did you get diluted? She told me: I don't know!!! I have to check! Holy Moly, this is a big issue and most entrepreneurs underestimate this topic until the moment they need to address it, when it may be too late! Let me try to explain why this is important.
When founders start a business, they usually own 100% of the company. During its lifetime, and mostly because of the company's financing rounds, founders get diluted (by issuing more shares to investors) and therefore decrease their ownership. Such dilution percentage accumulates across financing rounds.
While it is true that more money is better for your company and it may increase its chances for success, you must be sure to raise just the capital you need so you can balance both: succeed and maintain ownership. You should pay attention to not give up too much equity at early stages, or on unfriendly terms. These mistakes can unnecessarily dilute your stake in the company, making it difficult to attract further funding.
When a VC invests in a company, they largely invest in the founding team, so they need the founders to have the right incentive to stay in the company as long as it is necessary. In my experience, angel investors in a pre-seed round are generally looking to acquire around 20% of a company in return for supplying seed capital. At this moment, founders’ ownership goes down to around 80%. Then, in a Series A financing, venture capital (VC’s) will negotiate to obtain at least 10-20% ownership, so at this point, everyone (founders and angels) gets diluted; leaving founders with around 60-70% of equity, and in Series B founders will dilute around 16%… The story continues within multiple rounds of private financing.
There is no magic number on how much ownership founders should give up. If you have investors willing to invest, you have to negotiate and sometimes give up a little bit more than the ideal percentage you had in mind. For example, I’ve seen founders dilute up to 30% in seed financing, maintaining around 70% of the company.
In addition, founders need to attract employees. As the company’s most valuable assets, employees need to be treated accordingly. Sharing in the company’s long-term upside is the best way to retain, recognize, and reward employees’ commitment, especially when founders are competing with employers with deeper pockets. Investors wisely insist that companies reserve some stocks for their employees, known as Employees Stock Option Pool (“ESOP”), and this will be another dilutive event for stockholders, hence founders.
ESOP is an allocation of shares (common stocks) that will be granted to employees in the future, further diluting all the stockholders. Usually, pools are reflected as a separate section of the capital structure defining the specific percentage of the company that will be allocated to the employees, breaking down the company’s ownership into something like this:
Founders 50%
Seed investors 20%
Series A investors 20%
ESOP 10%
VCs usually look for an ESOP on a pre-money valuation when negotiating the financing round. This means that the shares for the option pool are coming out from the old shareholders, instead of being shared between old and new shareholders (including the VC). This, for the dilution, to affect the company and not the VC's position. In an upcoming article, I’ll guide you on ESOPs and how they are usually agreed (I promise!), but for now, let’s focus on dilution.
This is a very relevant point for VCs and is usually negotiated within the main terms of the term sheet, since this may result in different ownership (and returns) percentages. It is not the same for a VC to invest $2 million at a $20 million pre-money (which results in 10% of ownership) than to invest $2 million on a $22 million post-money (resulting in 9% of ownership, after a 10% dilution from the ESOP). When the option pool is set up after the VC financing, everyone (including the VC) is diluted as the percentage is taken from the company’s new capital.
Although founders get diluted, in some cases they get different vesting provisions than the rest of the employees since they are able to negotiate for “getting back” some stocks at a certain period of time. It is very important for founders to protect their position, and there are many ways to do that. Therefore, if you are part of the founding team make sure you participate in the ESOP.
In a nutshell: Pay attention to how much money you need to raise in order to minimize dilution. Founders will get diluted, accept it! But there are many aspects that can be negotiated to protect your position. Each financing series will dilute old shareholders’ positions. New investors will require the option pool to be increased in each financing (thus another diluting event), and finding a VC partner that really cares about founder ownership and who will be helpful for your success is a very important task.
I hope this was useful. Please make sure to share your thoughts and questions with me, and to suggest topics for upcoming articles!