Introduction to equity dilution

Equity dilution for a startup: the start-up ecosystem is heavily reliant on wealth creation and value generation. With such importance on the valuation component, stakeholders are continuously looking for varied structures to define the 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 the equity dilution mean?

The answer to this question is best explained with an example. 

Assume the Company is a piece of land. When you start your venture, there are only 2 people who are occupying this land (shareholders). Then you have an advisor and an ESOP pool is created. You have to share some parts of the land 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 shares. The reduction of your space/ percentage of shareholding as a shareholder is termed as a dilution of equity. 

What does primary sale vs secondary sale mean?

This question often comes across that founders are sceptical about giving away their shares when anyone wants a piece of the company. To address this issue, it's important to understand 2 primary concepts  - primary and secondary sales.

What is Primary Sale?

When the incoming investor wants to invest money in the Company and seeking for new shares to be allotted from the Company. In a primary investment, everyone gets diluted in the proportion of their shareholding, unless special conditions are mentioned.

What is Secondary Sale?

When the investor is looking to buy the already existing shares of the founder and other shareholders by paying money directly to them and not infusing any money into the company. No dilution 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 equity dilution work?

Fundamentally, each company is made of 100% shares (remember the one whole of something is always 100 %).  Let's understand this with an example to get clarity.

  • 2 Founders viz. A and B are holding 5,250 shares each with 50% of controlling interest in the company.
  • An investor, C comes with an investment of 1Mn dollar considering the valuation of 3Mn dollars

Now have a look at the figures in below table to understand this quickly:

Here, the number of shares has been increased basis the ratio to post investment i.e. 25% (1Mn/4Mn). The investor can keep any ratio post investment basis the agreement.

We can understand that post investment round, the holding % of founders are getting diluted and their controlling interest has been reduced from the original scenario.

How much equity to Dilute?

This question has no correct answer, it all depends on the stage of the business you are at. If you are doing great numbers - you can negotiate better else otherwise. Factors to consider the % dilution:

  • Too much dilution can be of concern to a future incoming investor
  • Too limited with founders is also concerning to investors as they should have skin in the game

Equity dilution for startup

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. 

What is Pre-Money Valuation?

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.

What is 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

Investors all offer equity-based on pre-money valuation however the % 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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