Equity Dilution in a Startup

After yesterday’s post Sell 20% of the Equity Per Round of Investment, I received a number of good comments about other factors that affect the equity splits between non-investors and investors. Overall, the main idea is that entrepreneurs often sell too much of their company too soon and should plan for multiple rounds of financing. Now, there are a number of things that affect equity percentages in a startup:

  • Pro-Rata Participation – Do the existing investors continue to participate pro-rata in subsequent rounds? Almost all investors require the option to continue putting money into a company to keep their ownership percentage in subsequent funding rounds.
  • Preferred Stock Preferences – Preferred stock, which is commonly sold to investors, often requires that it get paid back first before anyone else makes money. Sometimes, the preferred stock has a preference on it such that the investor gets a multiple of the money invested and then their percentage ownership of the company (e.g. they get a higher percentage of the financial proceeds, compared to equity ownership, until a certain amount is met).
  • Lines of Credit – Many venture banks, like Silicon Valley Bank and Square 1 Bank, ask for warrants in the range of .5% to 1% of the company as part of the loan.
  • Stock Option Plans – Typically, a new stock option plan and pool of equity is created after each funding round thereby diluting all shareholders.
  • Boards and Advisors – Independent board members and advisors to the startup are often compensated with equity in the range of .1-1% (board members earn more than advisors).

Of course, this doesn’t include the entrepreneurs, team members, and investors that own equity as well. Equity dilution is a normal and standard part of the startup world and it’s important to understand common items that influence it.

What else? What are some other items that can dilute equity in a startup?

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