Pre-money vs. post-money valuation
How much your stake is diluted depends on whether your funding round was priced at a pre-money or post-money valuation.
Let’s pretend an investor invests $1 million in your business at a $4 million valuation. For example, suppose your pre-money valuation is $4 million, and the investment brings that value up to $8 million. In that case, you will have an 80% stake in the company. A post-money valuation of $4 million would mean you control 75% of the firm after the investment.
When talking about the value of companies in the millions or even the billions of dollars, a difference of 5% may sound like little.
Convertible instruments issued before your round
Suppose you used securities like SAFEs or other convertible instruments to obtain capital. In that case, the point at which those instruments convert into equity is your price round.
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It’s easy to forget about your original investors when raising fresh, larger funding at a lower price point. However, considering the shares, you owe to all of your SAFE investors (including early investors) will provide you with a more comprehensive perspective on equity dilution. When you determine how much capital you need and how much equity you can afford to give up in your business.
Your option pool
During a pricing round, you could lose too much of your company’s equity if you create a larger option pool than you need. For example, if you want to provide future employees with a share of the company, you can set aside a portion of the shares in an option pool. However, option pools dilute your ownership because you are making new shares and adding them to your existing claims instead of taking them away.
It is common practice to create an option pool before issuing shares to investors to ensure that existing shareholders, rather than new investors, are retained. (This only affects you if you’re the sole shareholder.) In addition, they may urge you to make the option pool larger than is necessary to avoid the prospect of having to issue further options, thereby diluting their ownership in the near future.
Before setting the size of your employee option pool, you should decide how to hire people for the next year to two years and how many shares you will give new employees.
How to reduce share dilutiveness
When trying to raise capital for your company, every choice you make may significantly affect how much of the company you control and how much of the sale price you’ll ultimately receive.
Even though many of the factors mentioned above are inevitable, there are ways to reduce the impact of dilution:
Don’t raise more than what your company needs.
Borrowing money from investors early in a company’s life cycle is the most dilutive. This is because each dollar invested by an early investor gives them a greater piece of the company since they gain stock while it is worth less. However, you should know how much money you’ll need; securing extra seed capital isn’t simple, so you’ll want to plan ahead and aim for an amount that will propel your firm forward.
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Don’t make more options available than are necessary.
If investors want a larger allocation than is reasonable, having a hiring strategy to explain how you determined your optimal pool size might be an effective negotiating tool.
Take your time
Read the fine print of any term sheet or SAFE before signing. In the long run, you’ll pay for the choices you make today.
Conclusion
Founders should know the basics of dilution and cap tables. It’s a crucial indicator of fundraising success. Unfortunately, many entrepreneurs need to pay more attention to these principles. If the founder understands these concepts, they will have more say over the company’s shares.
