How to Think About Dilution

Episode Summary

Full Transcript

HEIDI: Welcome to The Startup Solution. I’m Heidi Roizen from Threshold Ventures.

Today, I want to talk about dilution. Dilution is what happens to the percentage of your startup that you own when you issue new shares. You issue those shares – for example, to sell them to investors or give them to employees – in the hopes that you’ll increase the ultimate value of your company by doing so. And that the increase will more than offset what that dilution costs you.

It’s impossible to know in advance whether all that dilution you’ll take over your startup’s life will be worth the trade. But while you can’t know that for sure, you can have a better understanding of when and why dilution happens so that you’ll be smarter about making the best trades possible.

.  .  .

To do that, let’s start with two foundational points that people often lose sight of along the way.

The first is this. There’s only, ever, and always 100% of a company. You can’t make more percent. You can create and issue more shares, but that will dilute all existing shareholders, including you. This will come up again later when I talk about pegging anything to a specific percent of the company, but for now, just remember, there’s always only 100% of any company.

The second thing to understand is the basic equation of how much you’ll make when you finally sell your company.

To be clear, most entrepreneurs I know didn't start their companies just to make money. But even if it isn’t the main goal, at some point, you’ll probably sell your shares either to an acquirer or in the public markets – and when you do, that liquidity can be a nice or even fantastic reward for all the hard work and long years you put in. So, it’s helpful to understand how that cash-out math is going to work.

The basic equation is this. Take the sale price of the company, and then subtract the amount of money that was invested in the company, plus any costs to sell the company, such as lawyers, bankers, and employee carve-outs. Take the amount of money left after doing that, and multiply it by your percentage ownership of the company at the close of the sale – and that’s about what you’ll get.

Now, you’ll probably end up with somewhat more than that because you probably raised funds by selling non-participating preferred stock, and that impacts this equation to your benefit. But this equation is a close enough approximation for the main points I want to make about dilution. And for those of you who have no idea what I’m talking about when I say non-participating preferred stock, I’ve put a link to an explanation in the show notes.

The take-away point here is that certain numbers in this equation really matter – how much you raised, which typically comes off the top before those percentages even come into play, how much the company sells for, and then ultimately what percentage you own at the end.

.  .  .

Let’s start at the very beginning – a single person with a great idea. In theory, that person owns 100% of the idea and the resulting company that will grow from it. But most startups need more than one person to get them off the ground. The person with the idea may not have the technical skills to create what they’ve envisioned. And even if they do, they may not know how to turn their technology into a market-ready product or how to attract customers. Or they may not actually want to run the company themselves.

Because of these and a myriad of other reasons, having co-founders is a very popular way to go. If you look at Y Combinator’s stats, for example, only about 8% of their top companies were solo founders. And according to a recent Carta survey, about ¾ of startups have co-founders. So, for most entrepreneurs, founder share allocation is the first dilution event they’ll face.

And the reality is, the most expensive “hires” you’ll ever make will likely be your co-founders – so you need to think very carefully about how to allocate that founder equity. There are all sorts of models for doing this and a wide range of guidelines for how much to give to whom. And I’ve put links to some of these in the show notes. But regardless of the amounts, there are two overarching considerations I want to bring to the forefront for you.

.  .  .

The first is, many co-founders leave before real value is built. And the second is, not all founders contribute equally, nor contribute the same amount of value over time. In my experience it’s rare to have a startup with multiple founders where those founders are in their same roles making their same level of contribution four years later.

Of course, you can’t know who’s going to stick around and who’s going to contribute what when you’re just starting out. But given the stats, it’s best to prepare for change to happen and plan accordingly.

This is one of those times where I strongly recommend experienced legal counsel to help you set this up. I recommend time-based vesting for all founders, plus some language that ties the original grant to the role that the person is to be playing. For example, if your original CTO is no longer scaling with the job requirements after 18 months, and you need to hire someone more senior above them, the original person should not continue to be compensated in equity vesting at the CTO level. It’s hard to renegotiate when stuff like this happens – so it’s best to set it up that way from the beginning.

What I like best are plans that award a smaller grant to each founder, just for being a ‘founder,’ and then another more substantial grant for each founder that is reflective of their role and the expectations for that role over the vesting period, which is usually four or five years. By setting it up this way, if the role changes, so does the grant. I think this better aligns equity compensation to the reality of how and when co-founders actually build value – and is fairer to everyone than loading people up at the beginning.

.  .  .

The next dilutive event you might face is joining a startup accelerator. Most of these require you to pay for their investment capital and value-added services with equity. I’ve posted both the Y Combinator and Techstars terms in the show notes, but the punchline is we’re talking 6-9% of your equity to participate. I’m not saying those are bad trade-offs; I’m just saying that you only have 100%, and there goes another 6-9% of it, so you’d better make sure it counts.

Let’s move on to the next form of dilution, selling shares in a venture round. That’s where angel investors and/or people like me come in. In the episode called The Case of the Verbal Term Sheet, I talked about some other early funding mechanisms like SAFE loans, which are loans that convert to equity down the line, and you might want to listen to that if you don’t know anything about SAFEs. But even with a SAFE, someday it will convert to equity, and hence dilution, so you ought to understand how that works before you take the money.

And at some point, you’ll want to do a priced round – where the SAFEs, if you have them, will convert to equity, plus existing and/or new investors will buy your stock for a certain price per share. The price per share determines the dilution you’ll take in the round, and generally, the higher the price, the less the dilution. But as I’ve said before, pay careful attention to the terms. Preference multiples, participating preferred, cumulative dividends, and ratchet provisions are all terms you should understand. They can result in more proceeds off the top to those investors – or even change the percentages to benefit them and not you if certain conditions occur.

The terms matter a lot, and for a primer on that, look to the show notes or to my episodes from season one called The Case of the Millionaire Mirage and The Case of the Downer Round. But the only way to fully understand the impact of the terms you’re offered is for you to model out various exit values to see how those terms will play out – because it’s usually much more complicated than it seems, and cap tables never tell the whole story.

.  .  .

Of course, how much you’ll need to raise over time, and therefore how much dilution you’ll take through all your fundraises will also dramatically impact what you’ll get in an ultimate liquidity event. The amount of dilution a startup will experience from all its capital raises will vary greatly from company to company. For example, total capital raised is particularly dilutive for capital-intensive businesses, where hundreds of millions of dollars will need to be raised and spent before any meaningful revenue can be generated.

On the other hand, super-efficient, high-margin companies, like many software companies, may only take on 20-25% dilution through all their fundraises. I’ve put a bunch of stats about typical dilution per round and at exit in the show notes, but I’d say that 40-50% total dilution from all financing activities is pretty standard.

For some companies, particularly software companies, there’s a trade-off between your burn rate and your growth rate – that is, you can raise less money and grow more slowly, or you can raise additional money to turbocharge your growth. This may be a good trade-off to make in a winner-take-all or winner-take-most business like I talked about in the last episode. In fact, it can be a good trade-off for many kinds of companies – if that weren’t the case, we venture capitalists wouldn’t have much to do.

But there are also non-dilutive ways to fund companies that are at the stage where there’s a high correlation between money put in and revenue growth. For example, the venture firm General Catalyst has a program that provides growth capital in the form of debt, and it profits from that by taking a cut of the additional revenue created by doing so. There are also companies like Capchase and Clearco that offer similar programs. That said, the days of zero interest rates are over, and these programs can cost you 5 to 20 percent of the money you generate with those dollars. So, while it’s not equity dilution per se, it’s still going to cost you.

.  .  .

Of course, another big area for dilution spend is other people – that is, employee equity. The topic of who to pay what varies for every company and every role, but it seems the amount of employee equity in aggregate, net of the founders at the time of a liquidity event, hovers around 20%.

Employee equity dilution is like an interest payment on long-term debt – that is, you have to keep paying it year after year. In fact, even after an IPO, a typical tech company will continue to dilute all of their shareholders every year through their stock-based compensation. This can cost anywhere from a single percent or two to even seven or eight percent annually. And this expense hits even the biggest, most successful companies – Microsoft, Apple, Alphabet, and Meta all burn somewhere between .2 and 1% per year for their employee equity plans. And just to give you a sense of the magnitude of the money we’re talking about here, in Apple’s case, for 2023, it was over ten billion dollars worth of stock.

Again, this is the way most successful businesses work, and there’s nothing wrong with it. In fact, I think broad-based employee equity programs are one of the most powerful tools an entrepreneur has to supercharge their company. But if you’re so lucky as to be one of these companies, you should expect meaningful single-digit dilution every year for the good fortune of having all those other amazing people work with you. So don’t be surprised when your ownership percentage goes down annually as a result.

.  .  .

There are still other kinds of dilution that can hit you, for example, “in-kind” business development deals where partners trade services, such as cloud computing or media placement, for equity or ask for warrants to purchase shares as part of some other transaction.

Simply put, if you’re issuing either outright shares or rights to future shares, such as warrants, you’re creating dilution. And you need to account for it, so you’re not surprised when the bill comes due. Always ask yourself, instead of this trade, if I had to sell shares to investors to pay cash for this, would I feel good about that? If not, you shouldn’t be trading shares for it, either, because it's really the same cost, just different forms of how to get there.

So, what’s a founder to do? My main point is to be very aware of every share you spend and to fully consider whether it’s in your best interest to do so. Understand how every business deal impacts your dilution. Look for other ways to avoid dilution if you’re in a tight situation. For example, by trading higher growth for additional runway and thereby putting off a financing until you can do so at a higher valuation.

Or even better, come up with some creative ways to generate my favorite non-dilutive form of capital – revenue. There may be interesting deals to do with large partners, like the kinds I talk about in the episode called The Case of the Strategic Sucker Punch. And, not only is revenue non-dilutive, it also validates your business and tends to raise your valuation for your next round too. There are so many reasons I love revenue!

.  .  .

Every founder should be mentally prepared that dilution is a fact of life, and don’t be surprised when your percentage goes down as a result. I admit it drives me a little crazy when a startup founder raises a big round and then complains that they ‘just want to be made whole again’ with respect to their equity percentage. Well, yeah, I’d like to be made whole again, too, but that’s not how this works. When there’s only ever 100%, the extra shares needed to make someone “whole” comes out of everyone else’s pockets, making them even less whole. Does that seem fair to you? It doesn’t to me.

Now, I’m not saying entrepreneurs shouldn’t get future grants for continued performance – that’s fair game. I’m just saying that when an entrepreneur or anyone else in the company latches on to their percentage ownership, they’re focused on the wrong number, and one that I guarantee will go down over time. This is why I think that all equity compensation should be expressed by a number of shares and imputed value, not by the percentage of the company it represents, because that’s always going to get lower, while, of course, the expectation is that the value of the shares granted will increase in value.

And that’s the point to take away from all this dilution talk – you’re giving up equity in your company in order to grow the value of your company and the value of the shares you yourself will have left at the end. And while you won’t know for sure that you’ve made good trades until that end, at least after today’s episode, I hope you’ll understand more fully what those trades are before you make them.

That concludes today’s episode of The Startup Solution. We hope you’ve enjoyed this episode, and if you have, please pass it along to someone who could use it. I’m Heidi Roizen from Threshold Ventures.

Further Reading

I mentioned that participating versus non-participating stock impacts the outcome equation. To understand what that means, read this, this, and this—and then hire a lawyer, because this stuff is complicated!

Here’s a great post from Stripe about the various ways to design founder equity allocation.

And here’s that YC stat about the small number of solo founders in their cohorts (the entire article is also useful info about whether or not to do a startup).

For those of you who want to trade equity to be in a startup program, here are the deals offered by Techstars and YC.

Here’s a nuts-and-bolts post about terms and their impact on dilution.  

This post includes some great data on how much dilution is typical in each round of venture capital.

There’s been a lot of recent press about non-dilutive growth funding, including a piece about some of the challenges revenue-based financing startups are having. There's also a rundown of other companies in the space here.

Another form of dilution is payment-in-kind deals, where you trade equity for products or services. This can come up in business development deals with large tech providers or corporate investors. Pros and cons are here.

Finally, I mention a whole bunch of my prior episodes that deal with the topics in this one. Here’s what they were:  

Here’s the episode that includes a discussion of what a SAFE note is: The Case of the Verbal Term Sheet

Here’s the episode that talks about revenue-generating deals with strategic partners: The Case of the Strategic Sucker Punch

Here are the episodes that talk about how much venture terms matter: The Case of the Millionaire Mirage and The Case of the Downer Round

Previous Episode