Raising capital for a startup is one of the most challenging yet exhilarating milestones in a startup’s evolution. On the one hand, capital is what makes the vision of the founders possible. Moreover, raising capital means someone else agrees with the promise of that vision and is willing to write a check to participate. It’s a huge affirmation of the company’s core premise.
On the other hand, raising capital – or even considering doing so – can be a highly emotional exercise for founders. Beyond the mechanics of how much to raise and under what conditions, sits the basic truth that raising capital necessarily means reducing the ownership of the original founders. This is not always an easy hurdle to cross. In fact, in our role as fractional CFOs for hundreds of venture-backed startups over the years, we’ve probably seen more anxiety around this tradeoff than with any other startup objective, with the possible exception of product-market fit.
Accepting that dilution is a fact of life for startup founders is the first step in determining how much of a company to part with in each successive round of financing. Despite innumerable opinions, there are no hard and fast rules for this question. It has multiple components, is more complex than it looks, and is very important to get right. We’ve seen more than a few founders finally reach a successful exit transaction but, because of bad dilution decisions early on, end up making tons of money for investors and precious little for themselves.
Accepting that dilution is a fact of life for startup founders is the first step in determining how much of a company to part with in each successive round of financing.
Before settling on what percentage to give up to investors, founders should ask themselves a few clarifying questions:
1. Think about the money.
The cardinal rule of raising capital for a startup is to sell a declining percentage of equity for an increasing valuation as the company scales. The higher the valuation, the less the founders have to give up for a given amount of investment capital. Early on, it can be tempting to over-finance, particularly when venture capital firms are clamoring to get a piece of the action.
But it can be a mistake. Yes, the old adage is to raise as much as you can whenever you can, but raising too much too early risks parting with an unnecessarily large portion of your company before your valuation has had a chance to grow. In other words, don’t try to raise $5M on an idea and a laptop – you’re much better off raising a lower amount, getting the idea off the ground and showing some market traction. At that point, your valuation will be higher, and upon your next capital raise, a given amount of capital will command a lower percentage of equity.
…raising too much too early risks parting with an unnecessarily large portion of your company before your valuation has had a chance to grow.
For example, say a pre-seed startup with a killer idea is offered $4M at an $8M valuation by a well-known early-stage VC firm. The founders are naturally flattered by such a high initial valuation, but it means parting with a whopping 50% of the business before it’s even off the ground. On the other hand, if the founders raised only $2M now at an $8M valuation and then, with a product built and in the marketplace, another $2M at, say, $15M, the total dilution for the same amount of invested capital is only 38%.
2. Think about how *much* you need to raise.
Note this does not mean how much you’d *like* to raise. That’s a different number. How much you *need* is a derived number based on how much it will cost to get to the next capital milestone and how much, if any, revenue you expect to generate over that period. Your forecast will ultimately prove to be inaccurate as the company grows, and that’s OK – Investors want to see that you’ve thought deeply about how the various levers in the company interact and how the engines for its growth will develop over time.
Hint: Big round numbers stick out like sore thumbs as if they’ve been plucked out of the air. If you say you’re raising $5M, have a good answer to the question “why $5M *exactly*? Why not $4.57M? Or $5.256M?” Precision is your friend when discussing how much capital you will need.
3. Think about equity.
Conventional wisdom says founders should assume they’ll part with 20-30% of the company in their first priced equity round, particularly a VC-led one, and 10-15% in each round thereafter. With a rising valuation, this means by the third or fourth round of financing, the original founders might only have 20-30% of the company, but that stake has become much more valuable. Would you’d rather have 80% of a $5M company (worth $4M) or 20% of a $50M one (worth $10M)?
Would you’d rather have 80% of a $5M company (worth $4M) or 20% of a $50M one (worth $10M)?
This is where we often see first-time founders have issues. They get jammed on selling equity beyond a majority threshold under the argument they want to retain control. This is reasonable but short-sighted. External capital is what makes a company truly grow, usually significantly faster and further than if it were self-financed. In return, those investors will want enough equity so that in an exit, when the company is far larger than it would have been otherwise, they make an attractive return. That’s the tradeoff – keeping majority ownership may mean being capital constrained, which translates to slower (or zero) growth; raising additional capital brings no single majority owner and oversight and assistance in the form of a board (not necessarily a bad thing), but fuel for the company to realize its full potential.
Important in this conversation is also how the capital is brought in. For early-stage companies where it may be too early to estimate valuation, financing instruments like convertible notes and Y Combinator’s SAFE (Simple Agreement for Future Equity) are terrific ways to bring initial capital in the door. They’re highly customizable through incentives like valuation caps and discounts and delay the real valuation conversation until there is more to measure. Note, though, that both these avenues convert into equity, so make sure you understand how the dilution will fully play out when these instruments convert.
4. Think about the option pool.
Lastly, think about the amount of equity you’d like to set aside for employee incentives. Few highly qualified people are interested in working at your startup for just the cash salary. Most, if not all, are interested in also receiving equity options so they can share in the value accretion that comes from growth. This is a tried-and-true incentive mechanism for startups of all stripes, and founders who are too cheap with the company’s equity do so at their own peril – truly exceptional developers and other critical hires will be nearly impossible to hire and/or retain without an option pool into which they can vest.
The rule of thumb here is to keep at least 10-15% of the company’s equity capitalization available for option grants at the start.
The rule of thumb here is to keep at least 10-15% of the company’s equity capitalization available for option grants at the start. Note this does not mean you have to issue options for the whole amount right away. Rather, having it carved out on the cap table keeps the pool visible and properly allocated as you grow. In some cases, you and your investors will plus-up this pool upon successive fundraising rounds to keep enough equity available for your growing headcount, and this is totally acceptable. In fact, most startups that reach Series B have employee pools at or near 20%, and need every bit of it to attract top talent.
Understanding how new capital will dilute existing shareholders *before* a round happens is a core responsibility of any startup CEO. Take the time to fully walk through the dilution process, the ramifications of it, and the math so you can make an informed decision about new capital. Armed with a full understanding of dilution, startup founders can raise money with confidence without worrying about being left out in the cold when it’s time to celebrate.