Continuing with yesterday’s post titled Dilution With Every Round of Financing, it’s instructive to walk through an example as a founder. Before the example, I like to highlight the stories of ultra-successful entrepreneurs that have taken their company public, and the vast majority own less than 20% of the equity at time of IPO (e.g. Marketo’s founder had 6.6% and Cvent’s founder had 16%) . Now, 20% of $500 million is still a massive number, but it’s a far cry from what people might otherwise think the entrepreneur owns.
Here’s an example walkthrough of dilution over several rounds of raising money:
- Two entrepreneurs come together and start a company, splitting the equity in half (so, each has 50% of the equity)
- Angel investors are excited about the working product and early customers, deciding to invest $300,000 for 20% of the business (the entrepreneur now owns 40%)
- Recruiting great early employees requires equity, so 10% of the shares are set aside for an employee stock option pool (the entrepreneur now owns 36%)
- Venture capitalists buy into the big vision, value the $1 million in recurring revenue milestone, and purchase 30% of the business for $3 million as part of a Series A round (the entrepreneur now owns 25%)
- Expansion of the employee base requires a new stock option plan, diluting everyone further by 15% (the entrepreneur now owns 21%)
- Growth is explosive and investors compete to be part of the $10 million Series B round, buying 25% of the business (the entrepreneur now owns 16%)
- Sales are skyrocketing and the paradox of more growth consuming more capital sets in requiring a $30 million Series C for 30% of the business (the entrepreneur now owns 11%)
So, after an angel round, three rounds of venture capital, and a couple employee stock option pools, the entrepreneur owns 11% of the company, and they haven’t gone public yet. Of course, the company is doing great and it’s better to own a slice of a watermelon than the majority of a grape.
What else? What are some other thoughts on founder dilution over multiple rounds of financing?
David Cummings on Startups 
Reblogged this on Moving Forward Through Innovation and commented:
This an excellent explanation of the process entrepreneurs will go through to get their discovery to market. I might add Bill Gates was a 9% shareholder at the point of Microsoft’s IPO.
This is a textbook example of how equity rounds are often raised and the resulting dilution. In the real world, however, things may be quite different:
If the idea is sufficiently big and successful, you might see much more money coming in much earlier and at much higher valuations (e.g. Google, Facebook, etc)….which is usually very positive for the founders from a dilution standpoint. The additional capital also gives the business much more “runway” to develop its sales and achieve significant revenue targets.
The other real world example is often a disaster for the founders and their equity holdings. Too often the business plan that money was raised on is missed and more equity must be raised. This is usually VERY PUNITIVE to the founders and early option holders. Hey, but should’t it be? They missed their objectives and did not achieve the things they promised their outside investors! And it really doesn’t matter why the plan is missed. Founders quickly find out that equity capital is the most expensive form of capital.
When considering a funding round, what would be “too much” dilution to accept? Would doing some sort of absolute dollar value analysis make sense? When considering the series A in the example above, and assuming it is used to grow revenue, what sort of increase should a founder look for in the dollar value of their equity?
I’d look at it less as “too much” dilution but rather how much larger does the company need to get by raising money vs not raising money to have a similar personal outcome. That number is usually about 5x (e.g. if you can get the company to $2 million in revenue without funding, with funding you should expected to get to $10 million in revenue).