One of the most common mistakes first-time entrepreneurs make is giving away too much equity, before or shortly after their launch. Typically, that happens because they either don’t understand or fail to model their dilution. Here’s a hypothetical example of how it works.
1. Idea Stage
So you started a company with a co-founder and agreed to divide equity 50/50. Fair enough. However, make sure you the ownership is subject to vesting, as you don’t want your co-founder to walk away with 50% of your company. This is typically done by signing a co-founder agreement.
2. Friends & Family Round – $300k Valuation
Let’s say you decided to raise $15,000 from your uncle in return for 5% of the equity. If 5% are now worth $15k that effectively makes your company worth $300,000. At least on the paper.
You also decide to set aside 20% option pool. This is equity that will be used to attract talent. As a startup you likely won’t be able to pay top salaries, so you want to be able to offer stock options to make up for it.
So you set 25% aside, and that means that the remaining 75% belong to you and your co-founder. That makes your share 37.5%.
3. Angel Round – $1 Million Pre-Money Valuation
So you’re about to release a beta version and need some money for further development. You’re raising an Angel round.
The angel investor agrees to invest at a pre-money valuation of $1 million. The pre-money valuation is the value of the company before you’ve raised your investment. Obviously, you progressed since you last raised money, so the value of the company went up.
You need $200,000, so instead of selling an existing equity you decide to issue new shares. Let’s say there were 1000 shares in the company, now each valued at $1000. To raise $200k you need to issue additional 200 shares.
The angel gets 200 shares, and the rest is divided as it was before, but now the total number of shares is 1200. 200 shares represents sixth of 1200, so all the previous shareholders’ percentage ownership is diluted by a sixth.
4. Series A Round – $4 Million Pre-Money Valuation
You gained traction, found a product-market fit, and so now you want to scale it. You decide to approach some VCs to get additional $2 million.
The terms are $2 million at $4 million pre-money valuation. That means you’ll have to increase the number of shares by 600. However, the VC also requires that you enlarge the option pool by an additional hundred shares prior to the deal.
So the total number of all shares you’ll issue is 750. To make it more interesting let’s assume you hired your first employee and offered him or her 36 shares, subject to vesting. Here’s your cap table.
As you can see, dilution is not to be underestimated. Basically, who has the equity elects the board members. And board members can fire you from the company, even if you were the original founder.
One way to avoid this is to keep preferred shares for you and your co-founder. Those are shares that give you extra voting rights to elect the board members.
Another bad case scenario is getting diluted to the point when you lose motivation to work on the company. A good VC should ensure this doesn’t happen, but bear in mind you started the process long before the first VC came on board.
So, the moral of the story is: model your dilution as giving away too much equity can be a serious mistake. For example, the founder of Kissmetrics (Neil Patel) makes a point about that:
“We made the mistake when we signed on a ton of advisors and gave many of them what they wanted early on. This caused us to use up our option pool faster than we would have otherwise, so when we raised our next round, we had to refresh our options pool to a full 10%. This caused my co-founder and me to get diluted more than we would have liked.”
“Treat your options as if they are gold. Hold onto them so you can give them to your key employees. If an advisor wants a lot of shares, make sure he/she gives you a written contract on what he/she is going to provide you with for those shares.”
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