Startup Dilution Explained as Simply as Possible

I had the opportunity to run Microsoft Azure’s Startup Accelerator in 2013. For 2 programs, we helped about 10 startups accelerate their businesses during a 3-month startup boot camp. Since Azure was the sponsor, there was a bit of technology work done, but the biggest gains for the startups were: 1) in their understanding of their customer and their business model; and 2) in their understanding of the mechanics of startup funding. To this day, I still find dilution over several investment rounds to be one of the most super-complex and super-intriguing concept in the startup funding space.

Why Do We Need Dilution for Startup Fundraising?

Before jumping into the mechanics, let me ask you a question: why do we need to dilute investors at all? If you were only going to raise a single round of funding, you do not need to dilute investors at all. You would say “I will give you this much of my company in exchange for that much capital.” Eventually, you either will come to terms of selling X% of your asset for $Y, or you will not, but dilution does not enter the equation.

Dilution only becomes an issue when you are going to raise capital over multiple rounds.

Why Are Multiple Round Investments Required for Startups?

For simplicity’s sake, let’s assume you have a really clear capital requirements ($100,000 needed today, $200,000 needed in 12 months, and $300,000 needed 24 months), and the only unknown is valuation. Certainly it would be logically possible to raise all of the money ($600,000) today, but no investor would want to give you capital for a super-risky startup so that you could park most of the cash in a bank for a couple of years. So that is not a realistic option.

You could also agree on valuations today, and then collect the money in 12 and 24 months as it is needed. But what if the startup flounders for 12 months: are the investors still required to invest at the initially agreed upon valuation? If you give the investors an option to renegotiate because the startup is not “killing it,” then wouldn’t any rational investor argue for a lower valuation in 12 months so that could increase their equity for the same investment? Certainly, you could imagine a bunch of performance criteria and contractual provisions that would establish the future valuation, but given the unpredictable nature of a startup this would be an impossible task to do well.

Multiple Rounds & Dilution to the Rescue

“Let’s All Negotiate Timing, Capital to Raise, and Valuation at Each Round”

Because it is so difficult to foresee what is going to happen in terms of capital requirements and valuation with startups, raising multiple rounds of capital, and diluting founders and earlier stage investors with each round of funding, has become the norm.

Turning back to the scenario ($100,000 needed today, $200,000 needed in 12 months, and $300,000 needed  in 24 months), we establish a first round where we are just trying to raise $100,000. Back of the napkin, startup investors are going to want to acquire between 20% and 40% of the company for EVERY SINGLE ROUND OF INVESTMENT. The way to think of this is not that your company is worth $500,000 because you are raising $100,000, but that your company better be worth $500,000 if you hope to raise $100,000.

First Round: Founders Diluted by 1st Round Investors

Let’s keep the math simple and say: the startup has pre-money valuation of $400,000; we are raising $100,000; and this gives us a post-money valuation (pre-money valuation + amount raised this investment round) of $500,000. Investors will end up with 20% equity (amount raised from investors this round / post-money valuation, or $100,000/$500,000 = 20%). The founders ownership in the company is diluted by 20%, so that their initial ownership (100%) is diluted to 80% (100% * 80% = 80%…the math will get more interesting next round:).

Pre-Money Valuation  $400,000
Amount Raised  $100,000
Post-Money Valuation  $500,000
Founder Ownership 80%
Round 1 Investor Ownership 20%

Second Round: Founders and 1st Round Investors Diluted by 2nd Round Investors

Fast forward 12 months, and the business needs to raise $200,000. The 2nd round investors may be the same set of investors or a new set of investors. The math is easiest if you assume they are different (and if there is an overlapping investor, she will be entitled to the sum of their first and second round of equity).

Assuming that the second round of investors want to acquire 20% of the company, we will see dilution in action. The 2nd round investors will get 20% of the equity, leaving the founders and the 1st round investors with 80% of their original equity positions.

 Round 1  Round 2
Pre-Money Valuation  $400,000  $800,000
Amount Raised  $100,000  $200,000
Post-Money Valuation  $500,000  $1,000,000
Founder Equity 80% 64%
Round 1 Investor Equity 20% 16%
Round 2 Investor Equity 20%

This may seem like a bad outcome for the 1st round investors, because they have been diluted from 20% to 16%, but they are better off. Now they own 16% of a $1,000,000 asset (or $160,000) instead of 20% of a $500,000 asset (or $100,000). The key for the early stage investors is that the asset needs to be growing faster than they are being diluted (when the dilution exceeds the increase in valuation, so that the early investors are financially worse off, this is called a down-round, or a bummer).

Third Round: Founders, 1st & 2nd Round Investors Diluted by 3rd Round Investors

Another 12 months, and we need to raise another $300,000. You know the drill, so here is the table.

 Round 1  Round 2  Round 3
Pre-Money Valuation  $400,000  $800,000 $1,200,000
Amount Raised  $100,000  $200,000 $300,000
Post-Money Valuation  $500,000  $1,000,000 $1,200,000
Founder Equity 80% 64% 51%
Round 1 Investor Equity 20% 16% 13%
Round 2 Investor Equity 20% 16%
Round 3 Investor Equity 20%

Startup is Sold (Hooray!)

Let’s assume that a year after the last round, we sell the company for a cool $3 million dollars. The funds are distributed in accordance with their final round equity positions.

Round 3 Sale
Sale Price  $3,000,000
Founder Equity 51% Founder Payout  $1,536,000
Round 1 Investor Equity 13% 1st Round Payout  $384,000
Round 2 Investor Equity 16% 2nd Round Payout  $480,000
Round 3 Investor Equity 20% 3rd Payout  $600,000

Even though the Round 1 investors are heavily diluted, they end up with a 284% ROI (after invested $100,000), while the Round 3 investors had no dilution, but a “measly” 100% ROI.  There are differences in the time value of money (1st round investors have their money tied up for 3 years), but that does not cause the difference in return. The main reason that the early investors get outsized gains is because they took significant risk. As the startup becomes more mature, the odds of failure become less (even though they are still high) and the returns typically reflect this decrease in risk.

Dilution Mechanics: That Was Not So Bad

The mechanics of dilution are not too bad when you break them down as a simple math problem. Where it gets complicated is when you throw in reality: what are your actual capital requirements (amount and timing of cash required to grow your business), what valuation will maximize your startup’s overall probability of success (not just closing this round), which investors are going to be most helpful to your company (if you are lucky enough to be able to choose), and how much time should you invest hunting investors instead of generating non-dilutive capital (aka – customer revenue:).

I hope that you found this useful. If you have any questions, drop me a comment. Thanks, and good luck favorably diluting your early investors!

Matt

 

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