07 March 2023
The start-up ecosystem is heavily reliant on wealth creation and value generation. With such importance on the valuation aspect, stakeholders are continuously looking for varied structures to define equity distribution of the company. Founders are often caught up in the tug of war between balancing costs and distributing equity of their companies. Although there are no fixed principles on which these distributions are done, the industry practice defines certain structures on a broad level that are followed by Founders for such equity distribution.
As founders, we are always worried about diluting our equity because for each one of us, we are the next unicorn in the making, and rightly so with the widespread use of technology and demand accelerating even in a pandemic, innovative businesses are here to stay and grow.
Through this post, we address the frequently asked questions about one of the most important aspects of a startup - “Equity Dilution”.
What does dilution of equity mean?
The answer to this question is best explained with an example.
ssume the Company is a piece of land. When a venture is started, assuming there are only two people who are occupying this land (shareholders/founders), the land would be divided between the two people either equally or based on a mutually agreed proportion. Then you bring on board an advisor and an ESOP pool is also created. A part of the land will have to be shared with them also, so the space you occupy on the land reduces. After this, you have investors coming to occupy the same piece of land along with you, so you need to further share your space. The net effect of this is that, as and when people keep getting added to your piece of land, your share of the land reduces. Applying the same principle to your company, the more people get added as shareholders, you make space for the others by reducing your share. The reduction of your space/ percentage of shareholding as a shareholder is termed as dilution of equity.
What does primary sale vs secondary sale mean?
This question often comes across that founders are skeptical about giving away their shares when anyone wants a piece of the company. To address this issue, it's important to understand two primary concepts - primary and secondary sale.
Primary Sale - Primary Sale happens when the incoming investor wants to invest money in the Company and seeks for new shares to be allotted from the Company. In a primary investment, everyone gets diluted in proportion of their shareholding, unless special conditions are mentioned.
Secondary Sale - When the investor is looking to buy the already existing shares of the founder or any other existing shareholders by paying money directly to them and not infusing any money into the company it is termed as secondary sale. No dilution or change in share of the other parties except the buyer and seller.
In 99.99% cases, the investor is always looking to do primary investment. It's generally only at series B, C etc where there is a possibility of a partial secondary sale to happen.
How does it work?
Fundamentally, each company is made of 100% shares (remember the whole of something is always 100 %). Let's understand this with an example to get clarity.
Now have a look at the figures in below table to understand this quickly:
Here, the number of shares has been increased based on the ratio to post-investment i.e. 25% (1Mn/4Mn). The investor can keep any ratio basis the mutual understanding.
We can understand that the post-investment round, the holding of founders are getting diluted and their controlling interest has been reduced from the original hold.
How much to Dilute?
This question has no correct answer, it all depends on the stage of the business you are at and a lot of other factors. If you are doing great numbers - you can negotiate better otherwise. Factors to consider the dilution are:
*This has been placed for general understanding and can vary as per the business scenarios/ factors
However, the ultimate goal is to grow the business. So even if the dilution numbers are skewed from the expected dilution you have in mind, the growth of the business is primary and an investment helps you to get closer to that goal.
Pre-money vs Post money
This is a simple concept that founders often struggle with.
Pre-Money Valuation is nothing but the value of the company prior to the company receiving the investment amount. Traditionally and technically, this value is derived through various internationally accepted valuation methods. Popular amongst them is the discounted cash flow method. With startups, this value is derived from the mutual negotiations entered into between the founders and the investors. It is alternatively called the ‘as on date value’ of the company. So if you were selling your company 100%, this is the value you would get. Investors all offer equity-based on pre-money valuation.
Post-Money Valuation in the simplest of terms is the value of the company after it receives the investment amount. If it were a mathematical equation, it would look like this:
Post-Money Valuation = Pre-Money Valuation + Investment Amount
All Investors offer equity-based on pre-money valuation however the percentage sought is based on the post-money valuation.
Conclusion: Understanding dilution and the captable is a pertinent metric of fundraising and talking to investors. We often see founders neglect it due to a lack of clarity of these concepts. A grasp on these concepts enables the founder to have better control of the shareholding.
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