It’s thrilling to go on a funding round because it shows that investors see potential in your business model and product roadmap. But taking on new money has long-term effects that must be carefully thought through, such as the dilution of shares.
What is share dilution?
This is called “share dilution” or “equity dilution.” When new shares are issued or reserved, the current shareholders’ percentage of ownership drops. It follows significant events like raising capital or establishing an employee stock option pool.
Say you are the sole shareholder in your business and possess 10,000 shares. Because business is booming, you’ve decided to set aside 1,000 shares for staff to use in purchasing stock options. You can get money by issuing 2,000 shares to an investor if you need money. You only own 77% of your company (10,000/13,000) instead of100% because there are now 13,000 shares of company stock (on a fully diluted basis).
When your share count decreases, your financial investment, and control over the business are both affected. Listed below, we will discuss two of the most frequent early-stage fundraising strategies.
SAFEs and equity dilution
Raising capital from investors in return for future ownership in your company is possible via the use of a SAFE (simple agreement for future equity). SAFEs can be a useful tool for startups to generate capital. Still, they also carry the risk of diluting existing shareholders.
When raising a SAFE, how does equity dilution work?
SAFEs can delay stock dilution until the next eligible funding round (usually your Series Seed or Series A). In exchange for their early investment in your firm, SAFE holders are promised a future payout in the form of shares. Because of this, the ownership percentages will be decided once a new company value is established.
Understanding and keeping an eye out for the effects of SAFE’s three primary influences — the SAFE, a valuation cap, and a conversion discount — will help you avoid any unpleasant surprises.
Which kind of SAFE will be issued?
Your eventual stock dilution may affect whether you raise pre-money or post-money SAFEs.
- Pre-money SAFEs, the ownership stake of each investor is fixed once the next funding round is completed. This SAFE may be preferable for founders because it dilutes all shareholders’ stakes simultaneously rather than selectively.
- Post-money SAFEs let investors predetermine their ownership stake in a firm before a priced financing round mixes in more investors. In the eyes of many investors and founders, this is preferable since it allows for more accurate ownership projections in the future. On the other hand, post-money SAFEs are less founder-friendly because they do nothing to increase the company’s value.
Before proceeding to the next stage (determining the valuation cap), you must choose the type of SAFE you wish to create.
What is your valuation cap?
The investor is safeguarded by the valuation cap included in many SAFEs. Suppose the company is valued at more than a certain valuation. In that case, the investor’s funds will not be converted into equity shares.
If your seed round valuation exceeds your SAFE valuation cap, you will need to offer your SAFE investors a lower price per share than your seed round investors to attract them.
You should know that giving a large number of shares to a SAFE holder will make you own a lot less of the company if the valuation of your priced round ends up being much higher than the valuation cap.
Is there a conversion discount?
When a SAFE is turned into stock, the investor gets a discount on the price of each share. This is called a “conversion discount.” For example, if your Series A investors are paying $1 per share, your SAFE holder might only have to pay $.80 for each share if they want to invest in your company. Although some companies may provide a discount for making the switch, this is only sometimes the case.
When investing in a SAFE that features a valuation cap and a conversion discount, the investor is better positioned to make a profit. Will typically get the lesser of the two per-share amounts (i.e., more shares for their money).
Priced rounds and equity dilution
A priced round raise takes more time and effort than a SAFE raise. Still, the dilution to existing shareholders is simpler to calculate. First, you and your investors agree on a valuation for your business. They then pay you a certain amount in exchange for a predetermined number of shares.
There are two main causes of dilution in a company: new investor shares and pricing rounds. During a priced fundraising round, the number of shares could go down because of the valuation method, convertible instruments, and the number of options that can be bought.
During a priced fundraising round, the number of shares could go down because of the valuation method, convertible instruments, and the number of options that can be bought.